When it comes to getting the most value for your money, it makes sense to measure the opportunity costs linked to where your money is being dispensed. Opportunity costs are based on a theory from microeconomics. It is based on making decisions that provide the best value for your money.
Many economic theories are just theories to the average person. They are discussed in the classroom or in the financial media, but the average individual investor does not receive too much practical application from most of these theories. They can be discussed, but not really applied to everyday life. The theory of opportunity costs does not fall into the category of academic mumbo-jumbo. It can easily be applied to the management of your personal finances. Paying attention to opportunity costs can totally change how you think about money.
What do you think about before you buy something? Most people only look at the direct cost. When most people decide to buy something, they just look in their wallet to see if they have enough money to pay for it. Some people don’t think at all and make the purchase with credit and just take on more debt to make the purchase.
The only time people tend to give any serious thought to what they are buying is when they are making major purchases. A good example of this is when someone decides to purchase a house. The potential home buyer will have their credit score checked, shop for the best interest rate, analyze how much they can afford in monthly payments, as well as many other considerations.
This type of thinking is not the most prudent form of financial management. Managing the finances around major purchases is important. Getting the big purchases right can make or break your financial situation.
Death from 1,000 cuts
The lesser financial decisions are also important. Not thinking about day-to-day spending can equally jeopardize a financial plan. The little costs add up quickly if a person is not mindful about their spending. They are like death from 1,000 cuts.
It is easy for small amounts of spending to get out of control. A couple of lunches out per week can add up to $100. Watching a movie at the cinema with snacks can cost $25 per person. Taking your kids to an indoor water park on the weekends can add up to hundreds of dollars. Without being mindful, the wasted spend can add up quickly and so do the wasted opportunities for that money to be put to use in a more prudent way.
When money is spent without thought, that is a sure way to not get the most value for the energy that you are exerting to earn it. To be successful with your personal finances, a consumer needs to be intentional. Otherwise, they are missing out on maximizing the opportunities that are available.
Always run the numbers
When making a financial decision, opportunity costs are based on weighing the pros and cons of how money is utilized. An example would be when you decide to buy a new car. When you establish the budget do you decide on buying a $30,000 car or a $20,000 car? If you decide on the $20,000 car, the additional $10,000 that you decided not to spend can be used to pay off debt or to be added to savings? Buying the $30,000 car would have $10,000 in wasted opportunity costs.
Being mindful of opportunity costs is a great way to maximize the value of your money. If you are trying to reach financial independence, getting the most bang for your buck needs to be front and center whenever you must spend money. By always evaluating the opportunity cost of a purchase helps to develop a savers mindset.
Tracking opportunity costs also have a role when it comes to managing investments. There is an opportunity cost involved with being too conservative with your selection of investments. If an investor kept all their savings in a money market account from 2007 until 2017, they would have earned less than 1%. If that investor put their money in an S&P 500 index fund, they would have earned almost 10% during that same time period. If an investor was not comfortable investing 100% in equities and wanted to invest in a more moderate allocation, they would have still earned 7.3% in the Vanguard Star Fund (VGSTX) that has an allocation of 60% in stocks and 40% in bonds.
If reaching financial independence is your goal, measuring the opportunity costs of all your purchases will help you get there. After you start to practice measuring the opportunity cost of every financial transaction for some time, it becomes like second nature. It is useful no matter where you are in the journey toward financial independence. If you are new to this way of life and working on paying off debt, it will help to curb your spending. If you are in the saving and investing phase, being mindful of opportunity costs will help you to free up more money to be used to build wealth. If you are entering retirement, keeping track of opportunity costs will help you to spend less and preserve your wealth.
Whenever I must spend money, I think about the opportunity cost tied to that purchase. I credit that thought process as helping to establish a high savings rate. It is a fun mental game to play. By being aware of how I am spending my money, it helps me to not miss out on all the better opportunities that are available for my money.
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