What is opportunity cost? I get asked this all the time. Just kidding, nobody asks me this. But here is why you need to know what it is: opportunity cost directly impacts every aspect of YOUR finances. In your personal economy, lost opportunity cost is everywhere.
Opportunity cost is defined as “the loss of potential gain from other alternatives when one alternative is chosen”. I break it down like this: opportunity cost is the potential future value of a spent dollar. If you buy a $25,000 car, that car didn’t just cost you $25,000. The lost opportunity cost is what that $25,000 could have earned if you had kept it and put it to work for you over a specified period.
It is very important to consider opportunity cost with big items. Many people look at the monthly payment of financing that car and don’t consider what else they are giving up having that car. Let’s say I bought that $25,000 car today and my hypothetical investment portfolio is earning just 5%. I reasonably have 40 years until retirement. The lost opportunity cost on that purchase would be the $25,000, plus the cost to finance it (let’s say $1,953 total of interest for a 5 year loan at 3%), plus the interest I could have earned, compounded each year for 40 years. That purchase would set me back $171,378 by the time I reach retirement.
What about multiple purchases? What if you bought a $4 fancy large iced green tea latte with no sweetener, extra matcha, two scoops of protein powder, light ice, shaken-not-stirred, every work day? That would be $20 a week, $85 a month, and $1,020 a year. That doesn’t seem harmful considering you are receiving value from enjoying the beverages. What does it look like over 40 years though? You will have spent $40,800 on delectable beverages and the lost opportunity cost on that chunk of change would be $88,577 for a total cost of $129,377! I personally don’t enjoy fancy drinks THAT much.
Keep in mind that my two examples above only assume a 5% rate of return. The higher the return you can earn, the larger the lost opportunity cost becomes. It isn’t realistic, nor would I ever recommend, that you stop enjoying your own transportation or fancy beverages. It is possible to have healthy finances and a secure retirement while still enjoying the journey to get there. I simply want you to recognize that your personal economy isn’t just effected by the cost to purchase, you have to consider the lost opportunity cost in addition!