You can live frugal, but still have a good life.
Living frugal does not mean you do not get to own nice things, go to fancy restaurants or have nice vacations. Make sure you have a balanced life. The next time you go on vacation, get a hotel with a kitchenette or an Airbnb so you can eat at home and save money on breakfast and lunch. By saving money on two meals a day you can splurge and go out to nicer dinners.
Opportunity cost is a term in finance and economics where you choose option A, and miss out on option B. The opportunity cost is the forgone benefit of the option you did not choose.
Let’s do an example:
You are in the market to purchase a home. Both are around the same price at $350,000, but one is in a well-developed neighborhood, and the other in an up and coming neighborhood. If you chose the home in the well-developed neighborhood, the opportunity cost would be the lost gain or appreciation you could have obtained with the home in the up and coming neighborhood.
In this example, you would want to look at the possible returns and appreciation each house would generate before you make an educated decision. If the home in the well-developed neighborhood increases in value by $50,000 and the home in the up and coming neighborhood increases in value by $100,000, your opportunity cost would be $50,000 lost.
Similarly, in business, you could choose to invest in new equipment and improvements to manufacturing or you could choose to pay down company debt. The option not chosen is the opportunity cost of your decision.
Opportunity cost spans all decisions
You choose one University over another, the school which you did not choose is the opportunity cost.
Other examples of opportunity cost is going to college or working. Another would be to start a business or work for a corporation. All our decisions come down to opportunity cost.
If you choose to pay down debt rather than investing, your opportunity cost is the missed appreciation and gain you could obtain when invested in the stock market.
As mentioned before, you need to live a balanced life. This goes for all decisions and the resulting opportunity cost. I do not believe there is a perfect plan for debt repayment or investing for your future. I do believe everything should be done in moderation.
If you were to only invest in the stock market, while paying minimums on your student loans, your will be paying more and more interest (do not forget, student loans accrue interest daily!). Sure, you might obtain 7% or so return on your money in the stock market, but could this money be used to pay down your debt more aggressively? Similarly, if you put all your money onto debt repayment and did not invest at all, you would miss out on price appreciation and possible dividend income of being an investor in the stock market.
How do you choose when faced with the opportunity cost?
- What makes you happier?
- What gives you less stress at the end of the day?
- Can you do a hybrid or mixed approach?
For example, if you are faced with the dilemma to invest versus paying down your student loans or a car note, you need to realize there is an emotional opportunity cost in addition to the actual opportunity cost between the two decisions.
If you are able to make 7% on your money in the stock market and you are paying 6% on your student loans, initially you might decide to just invest your money and pay the minimums on your student loans. Is there a right decision? I think a lot of personal finance opportunity cost decisions need to focus on the emotional impact. Becoming debt free is a great feeling, but missing out on stock market returns is equally challenging.
I believe there should be a hybrid approach to opportunity cost decision making. Decisions for one over the other, if it can be avoided should, but we are not always given this liberty. If you can invest for example in your company sponsored 401(k) plan and at a minimum (assuming they offer) the company match, you obtain a boost to your retirement savings. Remember, something is better than nothing!
While investing in stocks, you could also be paying extra towards your car note or student loans. If you decide to be focused on a hybrid approach like this, you will also need to recognize the missed opportunity cost. I believe a lot of poor financial choices are made when one is unable to realize the opportunity cost of their decisions.
I like nice things and so should other people, but there is a balance. If you are struggling financially, that new and shiny car looks great, but if you bought a used one, you would be less stressed emotionally and financially. Do not aim for materialism and showing off. Rather, aim for financial freedom.
The opportunity cost in all your life decisions is up to you. The decisions and choices you make today will impact your financial future. Are you making rich or poor decisions?
Your financial future is up to you and only you. What are you going to do about yours?
Until next time,