The Cost of Opportunity
Wait, no… that’s backwards. Opportunity Cost! That’s the one! For my 3 loyal readers out there, you may remember a post from about a month ago about this topic. Well I think it needs a little refining.
In my most recent post “Debt PEMDAS” I talked about this topic in relation to paying one loan over another. This works similar to investing. There is an opportunity cost in investing in, say, an equity with a higher expenses ratio or lower average returns.
What’s important to note about opportunity cost is that it’s not an abstract idea. Opportunity can be very straight forward. So for those that didn’t read my original post about opportunity cost, let’s just go over the basic concept. Opportunity cost is the just the result of the thing you didn’t do because of the thing you did do. The opportunity cost of going bowling with your family is that you can’t go to the movies with your friends. The point is that there is 1 resource and several paths for that 1 resource to take. In the above example, the resource is time.
For us students of the financial arts, our single resource or set of resources tends to be time and money. Whether you use your money to pay off debt, buy stuff, or invest, there is an opportunity cost associated with that.
Oh boy, he be gettin’ mathy
For debt, I strongly encourage you check out Debt Pemdas. It is the easiest to understand post regarding opportunity cost with debt. For investing and low interest debts, it gets a bit more complicated.
So for investments, unless you have a locked in interest rate, you will have to apply an assumed interest rate to future earnings. By this I simply mean that you need to estimate what you’ll be making on investments. For stock investing we tend to use 8% as historically this is about right depending on what you invest in and how you invest.
So now let’s compare paying down a mortgage for instance, to using that money to invest in VTI. First let’s track the mortgage. The average mortgage charges roughly 4% in interest per year. So, by overpaying by 500 dollars in the first month, you are saving yourself 4% of 500 dollars for the year (compounded monthly). This would come out to be $20.37 saved at the end of the year because of that 1 payment in January.
Now let’s got over the other option. Invest that money at 8% in the market. I am going to take out the compounding monthly as this is an estimation and leave it at a total gain of $40 (500*8%).
So which is which?
So if you were to pay down the mortgage, the opportunity cost would be $40 dollars in lost earnings, and if you were to invest, the opportunity cost would be the $20.37 in lost savings. BUT we have to compare them for your net gain. Take the choice you plan to take, then subtract the opportunity cost, if this is above 0, well you probably made the right choice.
If you choose to invest you would take the $40 gain subtract the $20.37 loss in savings and have a net gain of $19.63. This can also be translated into meaning that by being smart with your money, you made an extra $19.63!
Opportunity cost is like compound interest, if you understand it’s power, it can change your life. Understand that ever decision you make has an alternate outcome and by making the decisions that you do, you are costing yourself the opposing result. For every dollar you spend on things that don’t bring you value, the opportunity cost over years of investing is unimaginable.
A final note on opportunity cost
When talking about opportunity cost the way we are, in long term loans and investments, it is important to keep time frame in mind. Typically if you compare the result of the decision after a year vs the result of the other option after a year, you’ll have a pretty good idea of the right choice. Increasing the time frame will really just increase the difference.
For instance the interest saved by putting that $500 in your mortgage would en up roughly being $1156.75 vs $4,967.87 which it would have gained in the stock market.
Thank you for reading. I hope you found value in this post and have a better understanding of what opportunity cost is, as well as why you may not have to pay off all of your debt before investing.