You go to the deli and see two items you’d like to eat: a sandwich and a salad. You’ll obviously have to pay for both, but that’s not the only cost to consider. If you buy the salad, you will have sacrificed a tasty sandwich for lunch.
That’s opportunity cost.
“When you make a decision and commit to something, you’re by definition, in terms of money or resources, forgoing another opportunity,” says CFP professional Jonathan Duong, CFA, founder and president of Wealth Engineers in Denver.
You can’t have your cake, and eat it too.
Here’s how this principle affects your bottom line.
What is opportunity cost?
Many Americans struggle between paying down credit card debt and trying to earn some yield on their cash. If you use your money to pay off a credit card balance, you can’t then use that same money to invest in the stock market or earn interest in a CD or savings account.
It’s one or the other.
Life gets complicated when you weigh saving for your retirement against saving for your kid’s college education against paying down student loans against going to Tahiti for vacation.
How do I factor this into my investing plan?
You face a similar dynamic when it comes to your portfolio. A dollar invested in stocks is a dollar kept from bonds. How do you choose?
It depends on your investment horizon and risk tolerance. How long do you have to invest, and how much are you willing to lose?
Stocks historically have served up higher returns but with increased volatility. Bonds provide regular income but carry their own risks, such as falling in value when interest rates rise or inflation perks up.
“There may be investments you would like to have in your portfolio, but you only have so much money,” says Phillip Christenson, CFA, financial planner and portfolio manager at Phillip James Financial in Plymouth, Minnesota. “You can invest in bonds and money will grow, but it won’t grow as much as in stocks.”
A risk-averse investor may be tempted to invest only in fixed-income investments as a safety measure, but there may be a high opportunity cost associated with forgoing stocks. If you try to play it too safe by giving up the extra boost from stocks, you may actually fall short of your long-term goals.
Those nearing retirement, though, should be more willing to let go of potential stock gains in favor of the stability from bonds. In 2008, equities dropped 37 percent, while fixed income rose 5 percent.
Opportunity costs can be anything
If people ran their personal finances like a good business, each dollar would be put to its most efficient use.
“Because resources are scarce, managers must determine the best way to use them among a multitude of competing opportunities,” says Robert Stammers, director of investor engagement at the CFA Institute.
But you’re not a business; you’re a person.
While you need to save for retirement, build an emergency fund, and pay down debt, you also have others goals. You may be willing to give up earning a bonus if it means spending more time with your family. You may opt for a lower-paying job if it comes with more certainty.
Finding the right balance, then, can be tricky. The key is constant vigilance of your finances.
Before you spend a dollar you should ask yourself: Is there somewhere else you’d rather have it go?
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