How to Use Opportunity Cost to Make a Better Decision

MichaelEducation, Habits, How to, Misc, Personal Development21 Comments

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I have a confession.  I can’t remember 90% of the academic material I learned at University!

The good news is that the 10% of what I did retain has served me well.

One concept from my economics curriculum that stuck with me is the idea of OPPORTUNITY COST.

Definition

Opportunity Cost is defined as a benefit that a person could have received, but gave up, to take another course of action.

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This is just a fancy way of saying that choices leave you with trade-offs!

These trade-offs, or opportunity costs, are mutually exclusive meaning if you choose one, then you can’t do the other.

So What?

Why is this concept of Opportunity Cost so important?  Well, it affects nearly every area of our lives.

How you spend your time, manage your capital, or who you interact with all shape the quality of your life and ultimately your destiny.

So, it’s incredibly important to be able to make healthy decisions and examining your opportunity costs can help!

Examples

When I was considering an early retirement 3 years ago, I had to make a choice.  I couldn’t do both of these simultaneously.

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Choice 1: Continue working and earn a healthy 6-figure salary plus benefits

or

Choice 2: Retire early and become a stay-at-home Dad

Both of these choices were good, but which was better?  I decided to evaluate them from an opportunity cost standpoint.

 

Opportunity Cost of Choice 1: Miss out on my children’s prime years of development

Opportunity Cost of Choice 2: Forgo my prime working years, earning potential, and slow our net worth velocity

 

In the beginning, I closely considered Choice 1.  I thought earning more money would eventually lead to more freedom and choice later on with my family.  But, that thought was flawed.  You see, you can always gain more money at a later point in time, but you can never gain back the time you’ve lost.

So, I realized that Choice 2 was more aligned with my goal of building a closely connected family.  You see I grew up in a broken family for a good chunk of my childhood, so I value a strong family presence for my own children.

Finally, I realized that kids are more likely to want to hang out with you when they’re little, so I might as well get in the prime time with them now.  I can always go back to work when they are older and more independent.

 

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Here’s another simple example.  Should you attend University, or not?

Choice 1:  Attend University

Choice 2: Do NOT attend University

 

Opportunity Cost: Not being able to work and produce full-time income for 4 years

Opportunity Cost: Loss of increased lifetime earnings associated with having a college degree

Neither choice is inherently right or wrong.  But, once we add in some context, like your personal goals, then there is probably a choice that is more aligned with the attainment of your goal.

For the sake of argument, let’s say that you are more interested in building a larger income for yourself over the course of your career.  Well, then you would probably want to make the investment into attending University to increase your probability of finding a higher paying job.

Evaluate Your Goals and Outcomedetective-1424831_640

Where are you headed?  Do your current choices support this?

Since we’re talking about personal finances here, where are you currently?

– Consider these self-evaluation questions –

What’s the opportunity cost for NOT managing your own finances?

Opportunity cost: $Unknown!  How can you measure something if you don’t know where you’re at?  If you need some help figuring this out, check out my prior post How to Budget Like a Badass.

What’s the opportunity cost of 5 x $4 lattes a week?

Opportunity cost: $80/week or $160/month invested into an index fund earning 8% annually over 20 years = $88,608!

Now, I’m not typically one to suggest you get rid of a daily expense like coffee, I’d rather you figure out a way to make more income… BUT!  If you aren’t making headway with your financial goals, you should at least be aware of the costs of your actions.

Perhaps you scale back some, or other similar cash flow habits (going to watch movies, going out to eat, going to get a manicure… it all adds up!)?

What’s the opportunity cost of not asking for a raise?

Opportunity cost: $10,000+

This will depend on how much your base salary is, but it could feasibly translate to a 5-figure increase.  The problem is that we sometimes think the “system” should take care of us.  But, what if your company doesn’t do annual reviews?  What if you’ve taken on more responsibility and are providing more value to the company?  ASK!

What’s the opportunity cost of working in a job you hate?

Opportunity cost: priceless

This one doesn’t have a price tag because working a job you hate is just asinine!  Wake up.

There are always other opportunities out there.  If you don’t like what you’re doing, change it!

What’s the opportunity cost of working 80+ hours/week?

Opportunity cost: Time for yourself/friends/family

Now, this may be a fine and good decision in the short-term, but don’t fall into the long-term trap –  the workaholic’s rat race!  Consider the opportunity cost of time lost with loved ones and friends.  Chances are you won’t be able to be as present as you’d like to be with them.

What’s the opportunity cost of watching TV for 15 hours/week?

Opportunity cost: 15 hrs/wk = 60 hrs/mo = 720 hrs/yr = 30 days or 1 month of your life per year!!

I’m not suggesting that you stop watching TV, but maybe not so much!   Moderation is the key.  Imagine what you could do with a whole extra month in a year!

You could learn a whole new language, write a book, master a hobby, start a new business, etc…

What’s the opportunity cost of NOT starting that side business you’ve always wanted to do?

Opportunity cost: $0 – $1,000,000+

Is it entirely possible that you could start-up a business and fail?  You bet!  But, I can assure you if you don’t try, you will NEVER succeed with a business… that’s the opportunity cost… instant failure and regret!

Starting a business is not only exhilarating, but it helps to keep your mind active and is a ton of fun!  The rewards can be incredible too.  I can’t begin to tell you how many business owners I’ve met over the years who made a small fortune because they followed a silly dream… even when they didn’t believe in themselves 100%.

Why not you?

Of course, this list goes on and on, but you get the point.  It’s incredibly helpful to self-evaluate the opportunity costs in your life so you’re aware of the choices you are making every day.

Adjust

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So now you’re at least aware of where you’re at.  Are you okay with it?

I say, don’t become a victim to habit or monotony.  If you’re not acting in a way that supports your future goals… ADJUST.

Make sure you understand what you’re giving up so that you can appreciate your decision.

Make a conscious decision to change your current trajectory and DO IT.  I assure you, if you have a big enough WHY, you will find a way.

Remember, it all starts with the little actions.  Change doesn’t need to be difficult.  It only needs to happen.

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So what do you do if you don’t know the opportunity cost?  It’s okay!

Know yourself.  What kind of outcomes have you gotten in the past in similar situations?  Are you looking for different results?

Don’t get caught up in analysis paralysis.  You can’t analyze everything and try to optimize your life to the max, you’ll go crazy!

If you think you can’t do something… then perhaps you must do it then!

Don’t settle and wallow in the comfort of habits.  The ultimate opportunity cost could be the very freedom you’ve been looking for.

 

Readers, have you ever evaluated your opportunity costs (trade-offs) in life?  If you haven’t will you?  What’s the opportunity cost if you don’t?

 

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Michael

Hi, I have been blessed to take an early retirement in my mid-30's so I can focus on becoming a better father, blogger, and investor.

My goal is to help you find your personal path to financial freedom, and to enjoy the entire journey.

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21 Comments on “How to Use Opportunity Cost to Make a Better Decision”

  1. Nice post! Opportunity cost is the key to most all important decisions I make and evaluating it properly is paramount (not only the quantitative but qualitative factors). The other key to making the best decision is optionality which you hit on a little as well, for instance you having the option to always go back to work when the kids are older. Having the ability to easily change course if the decision doesn’t work out as expected can be a life saver!

    Thanks again for the thought provoking post!

  2. Lots of opportunity cost evaluations going on here! There are some career-related adventures in progress, and opportunity cost is playing a huge factor in making the right decision. Can’t wait to share some more details once everything shakes out 😉

    1. Oooh, yes can’t wait to hear details, Pia! I’m sure it’s very exciting (and a bit nerve wrecking?). Let me know eventually how it pans out and how opportunity cost influenced your decision. 🙂

  3. I don’t think in term of opportunity cost very often these days. I guess we are pretty comfortable where we are and there aren’t any huge decisions. The big decision for me was similar to your – keep working or quitting. In my mind, it was a bit more extreme. I was so stressed out and I felt like I was going to die early if I keep working. I mean losing a few years of life due to stress. You don’t want to trade health for money unless there is no other way.
    Yes, I’m sure our kid won’t want to hang out with me in just a few years. Time really flies.

    1. Wow, Joe… I’m glad you chose the early retirement path you did! Feeling stressed out of your mind is no way to live. Health over money is always an excellent choice since you can’t always get your health back!

  4. Like Joe, the big decision for me was to keep working or to stay home with my boys. Some days I still stress about money, but at least I don’t have to stress about work anymore.

    I have no idea what that’s worth, but it feels like alot!

    Great post Michael!

    1. Mr. Tako, it sounds like all of us early retirees had similar dilemmas when we were considering our exits.

      I suspect the opportunity costs were in the millions! Totally worth it. 😉

  5. The opportunity cost of not starting my business while working full time would have been more years of soulless work without growth. Now I am growing the business with the proceeds of my FT work. The soulless FT work now acts as a seed and is more bearable.

  6. Great post and a question if I may ask. When you were considering early retirement vs keep making that 6 figure income and you came to the conclusion that spending your time with your kids in their prime age is more important, were you scared that you might never be able to go back to corporate america?

    I was wondering this the other day and felt that one would have a hard time to convince an employer to hire him or her if they’ve been entrepreneuting (doing entrepreneurial pursuits) for such a long time. Thoughts would be appreciated!

    FS

    1. Fantastic question, FS!

      There’s always a little fear before making a huge transition. I was no different. However, I don’t think I worried much about ever coming back to corporate America. The main reason is because I’m confident there are thousands of great opportunities out there which would pay me well (independent of how the economy is doing) and I’d be able to contribute immensely in return.

      I guess being on the other side of the hiring table gave me an advantage of the employer’s perspective. So, if you came to me after a few years away, it wouldn’t matter so long as you could convince me you were a great fit for the current opportunity. And depending on the position, I might even favor your history because entrepreneurial pursuits tell me you are courageous enough to take action (regardless if it worked out or not).

      1. Thanks for responding, Michael! I can’t imagine making the plunge if I am ever in a position to do so but I thought I should find out now in case in the future I am in a position to do so. It helps appease my concerns a little bit 🙂

  7. Man, love the way you tell great stories using situations :)!
    Thanks for sharing & it’s made me reflect on a decision I made recently about whether to change roles to a different company & reduce what I’m earning although have awesome experience or stay at an organisation that pays well however may not be my 100% passion.. The key decision maker is that I want to travel next year for an undetermined amount of time, which requires a decent amount of savings..

    While taking the new role would have helped to bring me closer to creating financial literacy / education programs & coaching I felt it would have limited me doing the big trip..

    No right or wrong answer here however had to go with the gut really 🙂

    Keep up the cool posts

  8. Incredible post Michael. I’m currently running through this right now as I’m dabbling in various side hustles but I feel its taking away from real success. I would like to pick one and maximize it. Not being focused has a big opportunity cost!

    1. Thanks for sharing, Syed. I’m sure you’re not the only one dealing with this. I know from personal experience that it’s incredible tempting to dabble vs. focusing on a single hustle and pushing it through past the toughest points. Knowing your opportunity costs can definitely help you get past this. Good luck!

  9. You’ve got some really good examples here. The “watching TV” one is really eye opening. I remember I started my MBA program right after I started my first job and realized all I was doing at night was watching (terrible) movies on TV. I finally cracked down and said: there has got to be a better use for my time!

    I always think about the concept of opportunity cost when I see people trying to climb the corporate ladder so quickly. Yes, you’ll make $10,000 more per year, but at what cost? Working +20 hours more, traveling more often, more stress, etc.??? To me, it’s not worth it.

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