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Before we delve into the topic of opportunity cost, a disclaimer: In the eight minutes or so that it would take you to read this article, you could alternatively run for about a mile, bike two or three miles, watch eight minutes worth of cat videos, or have an extended debate on the merits of the Oxford comma. Basically, any other thing that takes about eight minutes.
That’s opportunity cost. When you choose to do one thing, you miss out on doing something else instead. It’s true when you spend time, it’s true when you spend money, and it’s equally true when you invest money.
It sounds simple enough, but the concept is easily misunderstood, as evidenced by this recent confusing comment on my timeshare article. Let’s explore COMO — the Cost Of Missing Out — further and learn how you can use it to make better decisions with your money and your time.
The Cost of the Thing
Some economists prefer to drop the word “opportunity” from “opportunity cost” because the cost in dollars (or your preferred currency) of the thing is precisely what you give up when you choose to purchase or invest in a thing.
I could choose to buy a $5 milkshake, or I could forego the milkshake and still have $5. The opportunity cost is $5.
The Thing(s) You Could Do With That Money
Another way to look at opportunity cost is what other things you could do with that money.
In the Midwest, that $5 could have gotten you a decent draft beer. Alternatively, you could have upgraded to sweet potato waffle fries or house-made tots.
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If you’re craving ice cream, that $5 would buy you a 64-oz 48-oz. [Thank you, shrinkflation] tub of ice cream, or even two of them when on sale. Now your whole family is enjoying a delightful dairy dessert!
The Things(s) You Could Do With That Time
How long does it take to savor a $5 milkshake? If you have it as dessert to wash down your double cheeseburger and crinkle-cut fries, it might keep you at the diner an extra 15 minutes.
That’s quite a few cat videos. Better yet, you could have squeezed in a 1-mile walk with that 15 minutes; even without the $5 milkshake, you’ve got some serious calories to burn off.
The Benefits of the Thing
To paraphrase Vincent Vega, the $5 milkshake tasted pretty effing good, and that was 30 years ago.
Adjusting for inflation, that same milkshake would go for $10.61, according to the US government’s CPI Inflation Calculator. One would expect a $10.61 milkshake today to be equally tasty today.
There is an opportunity cost to skipping the milkshake, of course.
You don’t get the immediate pleasure associated with slurping the thing down, and that is a missed opportunity, especially when said milkshake is being served by Steve Buscemi dressed up as Buddy Holly.
The Benefits of Not Doing the Thing
In addition to saving $5 (or $10.61) and possibly some time, foregoing the milkshake also keeps you from ingesting and digesting about 800 calories and gives your coronaries a bit of a reprieve.
They’ve got enough to worry about after the burger and fries, after all!
The Future Value of Money
The milkshake cost $5 in 1994. As the inflation calculator tells us, something that cost $5 then would cost just over $10 today. But what if Mr. Vega had not bought the shake but instead invested in the S&P 500?
The index, with dividends reinvested, has returned an annualized 10.34% from March 1994 to March 2024, for a total return of 1864%. That $5 invested back then would be worth $98.20 today.
If invested in a taxable account, there’d be a touch of tax drag, but there’d still be enough to buy at least 8 milkshakes at $10.61 apiece today.
This exemplifies why The Latte Factor is such a popular book. It’s easy to be dismissive of the benefits of saving five bucks a day; But when you consider the fact that a dollar not spent today could be 20 dollars in retirement, or $100,000 not spent today could be worth $2 Million in retirement, that’s some serious food for thought.
Real Life Examples of Opportunity Cost
5k Registration
My lovely wife started signing me up for running races early in our marriage. I was not a runner.
I briskly walked that first 5k in protest, telling her the same thing my athletic friend Pauly told the track coach in 6th grade. “I only run when the cops are chasing me.”
Over the next year or so, I also walked a 10k, a half marathon, and a marathon. By the end of all that, I felt I had made my point, and I decided it was time to actually start jogging.
Over the next decade, we ran countless 5k and 10k races, eventually getting our kids involved in running them with us.
After I retired in 2019, my wife and I have run a handful of official half marathons and one full marathon apiece. If I may humblebrag, a 5k is a short training run for us now. And it’s about half of what our kids run on an average fall or spring weekday when they’re in cross country or track practice.
Yet, a 5k is the most common fun run/race distance, and we’re inundated with opportunities to run them. What does that decision-making process look like these days?
We consider the opportunity cost.
If we sign up for a 5k for the four of us, the monetary cost is usually about $100 to $120 total. We’re also giving up an opportunity to sleep in on a Saturday morning and if we’re invited to a raging kegger social gathering on Friday evening, we have to consider the fact that we need to be up and at ’em and ready to run bright and early the next day.
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What are the benefits of signing up for the 5K? In other words, the opportunity costs of skipping it? If it’s local, we may have friends running it, and there’s a community aspect before and after the race.
It’s a good vibe, and most races are raising funds for charities and other worthy causes. And there’s the benefit of running 3.1 miles at a relatively quick pace, but it’s not like we can’t do that in our own neighborhood on our own schedule.
There’s a 6k (not a typo) that we’ve run many times as a family as an annual tradition, so we still run that one. There’s usually one more 5k and/or 10k each summer, but otherwise, we reserve our registered runs for the longer races of 13.1 or 26.2 miles.
I’ll be running the Medtronic Twin Cities Marathon this fall if anyone cares to join me!
The $100 we don’t spend on each and every local 5k could be $1,000 or more that each of my kids inherits one day. They’ll gladly take that along with the opportunity to sleep late on a lazy summer Saturday.
Buying a Timeshare. Or Solar Panels.
As I’ve lamented before, I’ve subjected myself to several timeshare pitches. More recently, I looked into the possibility of having solar panels installed on my new roof.
The sales pitches were surprisingly similar. Spend a bunch of money now for a small, ongoing benefit for a period of time until your “investment” is essentially worthless!
Well, the salespeople painted a much rosier picture, but that’s my fairly accurate interpretation.
The final numbers for the solar panels were something like this — keep in mind we live in northern Michigan just north of the 45th Parallel, a place known more for snow than sun.
The upfront cost of the panels and install, after a 30% tax rebate, would be about $40,000. My average monthly electricity bill savings would be about $150 a month or $1,800 a year.
That’s a yield of about 4.5% on a depreciating asset that, through degradation and obsolescence, will presumably be worth next to nothing in 25 years. Someone on their sales team had come up with a spreadsheet showing how this “investment” would come out way ahead of investing in a bond fund.
The numbers seemed fabricated and somehow didn’t account for compounding as far as I could tell. If I had access to the actual spreadsheet file rather than the .pdf they had sent me, I could have shown them the error of their ways, and believe me, I would have enjoyed that!
A timeshare, on the other hand, often depreciates massively over a period of about 25 minutes rather than 25 years when you buy directly from the issuer. You can buy them for pennies on the second-hand market; people often pay to get rid of them to save on the annual maintenance fees.
If the timeshare costs $40,000, the opportunity cost of not having that chunk of money to invest, plus, say, an additional $1,000 a year in maintenance fees, is huge.
You could pay for plenty of lodging with no limitations as to where to stay and when by using the investment earnings on $40,000. And you’d still have the original $40,000 in principal as long as your investment doesn’t lose money in the long run.
Taking the Family to Machu Picchu. Or Alaska.
These places have been on my 15-year old’s bucket list for some time. When I was 15, I just wanted to go to Dairy Queen, but I digress.
This summer, a Peruvian adventure or a two-week Alaskan adventure with a 7-day cruise would each cost somewhere between $5,000 and $10,000 apiece for our family of four. If the next 30 years are like the last 30 years, that money for each trip could turn into $100,000 to $200,000 if invested for a few decades.
There’s also the opportunity cost of spending that time away from northern Michigan when the weather is near perfect, people actually want to visit us, and the lake we live on is warm and unfrozen enough for boating and swimming.
And yet, we’re taking both trips, visiting Peru in June and Alaska in August.
As detailed above, there is a substantial opportunity cost in terms of both the future value of the money we’ll spend and what we might miss out on back home.
However, family travel is something we all value even more, especially now that we have two teenagers and know that we’ll never get to repeat these summers with them. Even next year, we’ll have a 16-year-old, presumably with a driver’s license and a summer job; our freedom to travel together will be limited, if not eliminated altogether.
This is a case in which FOMO beats out COMO when considering what means more to us at this time and place in our lives.
The Role of Opportunity Cost in Decision Making
I’ve highlighted how I consider opportunity cost when deciding whether or not to spend or invest in various things. How can you incorporate the concept into your own decision making?
Any time you decide to spend or invest, there are myriad other ways you could use that money.
On one hand, it’s easy to justify not spending the money when considering the future value of that money. I like to use the Rule of 72 to quickly determine what sort of growth to expect.
It could also be called the Rule of 70, which is actually more accurate, and it tells us that your money will double every 7 to 10 years when growing 7% to 10% per year. The number 72 (or 70) divided by the annual growth rate equals the number of years for your money to double. Simple back-of-the-envelope math.
On the other hand, we all know how easy it is to justify spending the money now because the future is uncertain, and hey, with all the hard work you do, you deserve it!
Happiness is all about experiences and connection with people, and quality time with friends and family is more valuable than any account balance.
Do you find yourself being pulled in the same direction too often and either saving excessively at the expense of meaningful experiences or doing the opposite? While living paycheck to paycheck? If that is the case, take some time and ponder the opportunity costs of the choices you’re making.
It’s important to set achievable financial goals that will set you up for financial independence in the future. If you’re easily meeting or exceeding them, ask yourself if you’re missing out on anything that might cost money now, but will enhance your general wellbeing or that of your family.
If you’ve got written financial goals but keep coming up short, drill home the true opportunity cost of spending money now versus having all of it and a whole lot more for your future self.
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If you have no particular financial plan or goals, get your act together. The opportunity cost of not doing so is too great!
7 thoughts on “Understand Opportunity Cost and Make Better Decisions”
I was so happy to see the author of this article! I very much enjoy your writing style, Leif, and the links you embed within the article for additional laughs. I just had to go reread the timeshare article. Fully agree that opportunity cost must be accounted for when buying something or spending time. We had some solar panel people come by recently; I’ll keep your thoughts in mind when people show up to my doorstep selling something.
Happy to see you, Marcus!
Considering the future value of money not spent and using the Rule of 72 to understand you could have 4x or 8x in 15 to 20 years is so important, especially for those who repeatedly overspend and underinvest in their futures. I don’t write nearly as much as I used to, but it was fun to put this post together, and it’s a topic I wanted to get out there.
Cheers!
-Leif
I personally think Solar is great! Good for the environment and good for the pocket. Maybe it is state specific but where I am at, we got solar for $21k after 30% federal tax rebate. My monthly energy bill is $205 and we get paid by the state for putting energy into the grid…about $50/month. So if I do my calculations right, we are yielding 14.5%! Sure the panels are depreciating but so is our cars.
I sure wish the math worked out like that for me. I was going to get a little more than half the benefit for twice the cost. I’m a fan of the technology, but in my case, its application made zero financial sense. Perhaps if I were to DIY like my friend Carl did, the math would work out much better. Pleased to hear it worked well for you!
Cheers!
-Leif
Great article. I fell for timeshares at a time long before AirBnB. I also had opportunity costs as a lad when I spent 90% of my money on women and booze and wasted the other 10%.
Nice article Leif!
One neat trick around the solar panels is that you can bundle other repairs in most states and get tax deductions for those alongside the installation. So if you have a 1900s 4plex house-hacking investment like I did when I became an attending, I could bundle it with an electrical upgrade and roof repair and deduct the whole expense. Otherwise, agree – the opportunity cost doesn’t make sense for most 🙂
Thanks, Nirav. That is a cool trick, and I’m glad it worked out for you with your house hack. I hadn’t heard about the opportunity to bundle other repairs and get a bigger tax break. It may be state-specific, but if you can make solar energy work well in rainy Washington state, you’re doing very well for yourself!
Cheers!
Leif