Opportunity Cost: A Crucial Factor in Personal Finance

Picture it:

You’ve saved up $100 at the end of the month.

You said you wanted to start investing, but you’ve also found a new pair of shoes you want for $100.

You know you can’t do both, so you have a decision to make.

Every time you buy something, you’re eliminating the opportunity to buy something else.

We call this opportunity cost, and it’s one of many forgotten rules of personal finance.

So, I’m going to help you understand:

• What is opportunity cost?

• Why it’s so important.

• The 3 common examples of opportunity cost in modern society.

What is Opportunity Cost?

The opportunity cost is an economic term which recognises the value of the best foregone alternative when deciding to buy something.

It’s commonly used in economics, but can also be used in personal finance to describe the things that people miss out on when they make certain financial decisions.

Say you have $100 for a new pair of shoes, and you’re torn between two pairs which both cost $100.

You know you can’y buy both pairs, so you know you’re going to miss out on one of the pairs that you want.

• Pair A — White.

• Pair B — Blue.

Say you go for the blue pair, the opportunity cost is Pair A, because this is what you’ve missed out on.

Opportunity cost is everywhere, but the skill is acknowledging it, which is something that very few people do.

If you buy something, this automatically means you miss out on other things.

So, to improve your spending habits, it’s important to make sure you’re buying the best thing possible with your money, at any given time.

The formula for opportunity cost is:

Opportunity Cost = Foregone Option — Chosen Option

Only you will know the value of the foregone & chosen options at any given time, so it’s up to you to determine whether something is worth buying.

Why It’s Important

The importance of recognising an opportunity cost is so you can improve your spending habits, and make better spending decisions to improve your life.

The money we all have is finite, meaning we have a limited amount of it.

We all have different amounts, but it’s important to recognise that whilst you can do one thing with your money, you lose the opportunity to do something else.

And by simply acknowledging the existence of an opportunity cost, you can improve your spending habits drastically.

A lot of people have poor spending habits, and a lot of people know this, too.

• Impulse purchases.

• Delayed gratification.

• Peer pressure.

But, if you take just a couple of seconds to acknowledge a superior option, you can avoid a huge amount poor spending.

I spoke about this recently when talking about my 100 day rule, the worst part about buying something that you know you shouldn’t have, is the regret.

I’ve been there:

• Video games.

• Clothes.

• Other useless stuff.

Spending $70 on a video game to only play it for a few hours, and never do it again.

But, if I would’ve thought to myself, “think about what else you could buy with that money,” I could have stopped by myself.

• I could’ve invested the money.

• I could’ve learnt a new skill with that money.

• I could’ve bought another game that I would’ve played for more than a few hours.

See what I mean?

The mere acknowledgement of an opportunity cost can save you hundreds each month, and tens or hundreds of thousands over your lifetime.

3 Common Examples

Time

If you have something that’s limited in supply, there will be opportunity costs, and there isn’t a better example of this than your time.

How you spend your time has huge implications on where you are in the future.

You can use the same structure of a financial budget to find ways of optimising your spare time so you can avoid wasting time on meaningless activities:

• Doomscrolling

• Video Games

• Netflix

I’m not saying these are all bad things, I’m just saying that a lot of people spend too much time on them.

I still play video games, but I’d say that since I started time budgeting, I’ve reduced my time gaming by 90%.

Time is the most valuable commodity in our lives, and knowing that time is gone forever once it’s passed, you can begin to make the most of your time by spending it doing more meaningful things.

My advice to you? Start time budgeting.

Money

When it comes to money, there are tens, or even hundreds of opportunity costs with every transaction you make.

You’ll never be perfect, and it’s important not to judge every purchase for it’s financial gain.

You might be saving up to visit a place you’ve always wanted to go to, so in your case, this would be the optimal way to spend your money.

Would spending $100 on a new pair of shoes help you get there?

No, so make this the opportunity cost. NOT what you truly want the most:

The holiday.

The problem a lot of people have, is that they fail to recognise an opportunity cost, so will spend their money poorly for the sake of instant gratification.

Don’t be this person.

Your money is finite, and more valuable than you think.

Attention

This is similar to the time point, but your attention and focus is invaluable, and you should (this is gonna sound funny) pay attention to what you give attention to.

I think Keanu Reeves has a famous quote about this, but I’m at a point where I don’t care to argue or debate anything anymore. It’s pointless.

Someone could tell me to my face that 2+2=5, and despite being a massive maths nerd, I’d agree with them just to avoid the pointless little argument that would ensue.

Why do I do this?

Because I’ve acknowledged the opportunity cost, and in this case, starting that argument (it’s similar to the “time” element too) is almost the worst thing I can do for my limited, valuable attention.

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