What Is Opportunity Cost In Personal Finance?

what is opportunity cost
Kevin Wenke

Kevin Wenke

CFP | CLU | Investing | Insurances | Taxes

Opportunity Cost | Table of Contents

An introduction to opportunity costs

what is opportunity cost

When it comes to personal finance, opportunity cost is an important concept to understand, but it isn’t something many people consider when making decisions.

This is because we are conditioned to think of “costs” regarding how much money was spent on something. 

For example, we say things like: 

– The insurance policy costs $100 a month.

– The mutual fund costs 1.5% of the value of our portfolio.

Opportunity costs are somewhat intangible since you don’t purchase the item that creates the cost. You also don’t get the value the item potentially creates either.

We take opportunity cost VERY SERIOUSLY here at Decision Tree Financial. As a matter of fact, it is a big reason we named the company what we did.

My hope for you is that after reading this post, you understand opportunity costs better, and the incite can help you make smarter financial decisions.

This is because considering opportunity costs will help you choose the better alternative of where to allocate your resources over other possibilities. This will give you more value and put more money in your pockets while allowing you also to do more of what you want to do today.

In other words, understanding opportunity costs and making better decisions will prevent you from saying “what could have been” if you had known and done things differently. 

Let’s take a closer look at opportunity cost and how it relates to personal finance

Opportunity cost in economics

In microeconomics, opportunity cost is:

“The cost of foregone alternatives when an economic decision is made.”

In other words, it is the benefits that could have been obtained by taking a different course of action or “what could have been.”

Opportunity cost is a key concept in understanding the basic economic problem of scarcity.

In a wider perspective, opportunity cost may also be the cost of lost potential, such as the cost of not going to college or the cost of not investing in a business venture.

In these cases, opportunity cost represents the next best alternative that was not chosen.

When faced with a choice, we can compare the costs and benefits of each option to choose the one that will provide us with the most net benefit.

By understanding opportunity cost, we can make decisions that are in our best interest and avoid making choices that will potentially leave us worse off.

Example of opportunity cost in personal finance

Imagine you are a 40-year-old making $100,000 a year and you have  $10,000 that you want to use to secure your future. You love what you do and have no plans on retiring.

You also believe without a doubt you will increase your earnings to $150,000 per year next year if you keep doing what you are doing. A 50% raise!

That sounds awesome – Congratulations!

You also have a “hot tip” and believe an investment you know about could “pop” and take your $10,000 and turn it into $50,000 to $100,000 in the next 10 years. You give it a 75% chance it will do that and an almost ZERO chance it will lose value.

Sounds like a good opportunity but what is the potential opportunity cost?

You met with me, your CFP, to discuss this, and I look at your financial positions and say to you, “even if you lose that money, you will still be able to meet all your financial goals IF everything goes as planned…

The IF is the big unknown, though.

One thing I point out to you is that you do not have a plan in place to compensate yourself IF you become sick or injured and are no longer able to work. Putting that plan in place would cost you $2,000 per year.

Now you start thinking to yourself:

 “I have always been able to work, and I have never been sick or injured so bad I wasn’t able to, and I don’t plan on having that happen…”

BUT

“If it did happen, it could cost me MILLIONS in lost earnings.”

Your choice in this example is:

  1. Do you use that money to invest with the potential of turning it into $50,000 or
  2. Do you set it aside and use it to purchase a disability income replacement policy to protect your earning potential, which is $2M+ Dollars?

It is true, having an extra $40,000 to spend in 10 years would be nice but not life-changing…

On the other hand, losing your ability to work and MILLIONS of DOLLARS would be DEVASTATING

Sure, there is just a slim chance of you becoming disabled during your life but there is still a chance. This, coupled with the high likelihood of you receiving a future raise and increased earnings, has you picking the insurance protection.

You chose to purchase disability insurance and forgo the investment opportunity.

The opportunity cost you accept is the lost potential of the investment’s possible return. Had you purchased the investment and not the insurance, the opportunity cost of not having coverage could be Millions.

These are the types of choices we face when considering opportunity cost.

(5) Questions to ask yourself when considering opportunity costs in your life

Let’s breakdown the five questions that you would be asking in the previous example between choosing to invest or buy insurance to protect your income with the $10,000 you had available.

What is the best case scenario?

In our example above, the best case example was the investment would turn $10,000 into $50,000 in 10 years, while the best case scenario for your work would be you would get a raise and continue doing what you love making Millions of Dollars during your working life. 

What is the worse case scenario?

The worst-case scenario for the investment you believed would be that the investment stayed flat, and all you would have is what you started with after 10 years – 10,000 dollars.

However, the worst-case scenario for you being unable to work was Millions of Dollars in lost earnings.

What is the probability of success?

The probability of your investment going up to $50,000 was 75%, while you believed the likelihood of your income going from $100,000 per year to $150,000 was almost certain. 

What is the likelihood of failure?

The chances you will experience a major illness or accident that prevents you from ever working again are low. However, this is a chance and as a matter of fact, the odds a 40-year-old becomes disabled during their life for 3 months, or more is 30%!

For your investment, you didn’t think it would go down but gave it a 25% chance of not performing as you thought. The odds may be low it could fail and be worthless, but there is a chance of that too.

What decision makes you feel most confident about your future?

This is the gut check question when it comes to opportunity cost.

How do you feel about your choice?

You don’t want to look back and regret what you did or didn’t do, so you have to imagine what your life would be like if the best and worse case scenarios happened.

Conclusion regarding opportunity cost

This was a make-believe exercise we went through to illustrate what an opportunity cost is. In reality, it isn’t too far away from some of the conversations I have had with some of you.

If the investment example was into a business that you worked and controlled, which held the potential to make you millions a year but could more easily be worth nothing, you may choose to roll the dice because success would be life-altering.

You were 40, and you could make it back if you failed. The worst thing is being 70 years old or more, looking back and regretting what you didn’t go for.

There are so many choices and factors to consider when making financial decisions. 

Your values also play a key role in the direction you will take.

Another consideration you will want to understand is that you may be able to do more with less if you look at your options a little differently.

This requires new information and asking questions you never thought of asking.

The SALLO Investment Strategy we use helps our clients both invest and protect their future without sacrificing long-term returns.

How?

By getting more value out of the money you invest and thinking differently than you currently do… 

You can check The SALLO Strategy out by clicking here if you are into getting more out of your money and reducing the opportunity cost of one choice over another.

Go ahead, check it out so you can know what is possible.

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