Everyone (yes, even millionaires) has a limited amount of money. If you want to maximize the money you do have, you should always consider the opportunity cost. So what is opportunity cost?
The official definition of opportunity cost in economics: “The value of the best alternative forgone, in a situation in which a choice needs to be made between a variety of alternatives given finite resources”.
Sorry! I know I promised to keep this blog fun, and even typing that was boring!
Let’s make this interesting!
Opportunity cost is what you must forgo in order to get something else.
According to Wikipedia (obviously a reputable source) it’s “The value of the most valuable choice out of those that were not taken”.
The sacrifice of one thing to obtain another is called the trade off, while the thing sacrificed is called the opportunity cost. Basically think of the trade off as the process of selection that you go through, while the opportunity cost is the thing that is sacrificed (not selected).
Always consider the opportunity cost!
Life is a series of choices of one thing over another. We do it all day, typically without even really thinking about it. However, these decisions can have massive impacts on our time, money, and lifestyle. You’ll need to live with the consequences, so at least make an informed decision!
Instead of just thinking “I want that”, stop and consider “Do I want THAT more than I want THIS”.
There is only so much money, and you can only spend each dollar once.
Weigh your options before choosing one alternative over the other. The goal should be to choose the option that leads to the most value. The best part? Value is defined by YOU! What you value will likely be drastically different than what I value.
Let’s consider some examples:
Say you need your daily caffeine fix. I completely understand that (don’t even talk to me before coffee in the morning).
In a simplified world, we’re going to consider 4 possible scenarios:
- You LOVE your daily latte, so you stop at your favorite coffee shop every morning and spend $5. Over the course of a month, you spend $150 dollars ($5 x 30 days)
- You value good coffee, so you buy some local coffee beans (let’s say beans for a month cost you $40). You make yourself coffee at home every morning.
- A caffeine fix is required, but you don’t care what it tastes like. You buy cheap pre-ground coffee for $10 a month.
- You decide that you cannot afford your caffeine addiction anymore, so you give up coffee entirely.
So, what are the opportunity costs here? Say you choose option 1 as your daily routine, and option 2 would be your second choice. By choosing the daily latte, you are giving up an extra 20 minutes of sleep (because making coffee at home is faster in the morning), and spending $110 more.
So you aren’t choosing fancy coffee versus less fancy. You’re choosing fancy coffee over good homemade coffee AND more sleep AND $110 available to spend somewhere else (possibly a fancy coffee maker for home?). Option 1 is fine (if you can afford it), but be conscious of what you’re giving up to have your choices.
Let’s do another example…
One area in particular that I think people should stop and consider opportunity costs is the vehicle they buy. Besides your house, your vehicle is often the most expensive thing you own.
My dream vehicle is a Volvo XC90. Every time I see one I drool a little.
What I currently drive is a Toyota Rav4.
According to both companies websites, the Volvo starts at $59,750 while the Toyota starts at $27,990 (both are base models to keep this example simple).
So when choosing between the two vehicles, I’m not really just choosing a vehicle. The opportunity cost is the other things I could have PLUS the vehicle.
The opportunity cost is asking “What could I do with this money instead?”
I wouldn’t be choosing between a XC90 and a Rav 4. I’d be choosing between a Volvo versus a Toyota and a spare $31,760 (which could easily pay for my dream trips to Patagonia, Switzerland, Iceland, and Nepal).
I’m choosing between owning a luxury vehicle, or a perfectly fantastic vehicle plus the hikes I’ve dreamed of for years.
For me, that makes the decision easy. Sorry Volvo, you’re gorgeous, but you’re simply not worth what I would be sacrificing to get you.
Make sure you always consider the opportunity cost!
It’s a powerful way of making you think through your choices, because each thing you buy represents something else you now cannot buy.
Cheaper is not always better. It’s about determining an item’s (or experience’s) value for YOU. In the coffee scenario, I would choose option 2 [good local beans]. Sure, cheaper beans exist! However, I’m personally a coffee snob. I like something that tastes amazing first thing in the morning. [We aren’t even going to consider option 4, because giving up coffee feels unfathomable to me].
You’re free to make any choices you want in life, but you’re not free from the consequences of those decisions. Choose the option that gives you the most bang for your buck, and you’ll quickly get the most happiness from your hard earned dollars.
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