The Costs of Not Understanding Opportunity Costs

Did you ever go to the mall to play arcade games as a kid? You know, back in the day before walking into an arcade was the first step in completing your application to be featured on an episode 48 Hours: Sunday Night Mystery.

Afternoon arcade gaming was the best. I don’t know about you, but looking at an oversized pencil and thinking to your eight-year-old self, “What the heck would I do with this?”, and still using your tickets to purchase it was pure hedonic pleasure.

But those arcade games taught me a rough lesson.

I could have anything I wanted…I just counldn’t have everything I wanted.

arcade tickets 2I remember standing in line with an overflowing bucket of tickets. I worked hard for those tickets and had the sweaty, pizza stained t-shirt to prove it.

I had my eye on an oversized, mean-looking grizzly bear that was sure to never be played with. But that didn’t stop my craving to have it.

As I was standing in line I noticed a few other things on the other end of the glass table so I walked over. There was generic gum that would turn into a rock within 10 seconds, those green army guys to put under your parent’s feet when they tried to go to the bathroom in the middle of the night, marbles I could easily swallow, and a fake snake. Heck, those would be cool for a few hours (more than most toys). So I got them.

I went back over to the other line. My turn was next. It was my time to shine: “I’ll take that big teddy bear for my sister’s birthday” (I don’t have a sister). I plopped my bucket of tickets on the counter and proudly proclaimed, “I have enough”. My mom had counted them on the way to the arcade.

The man behind the counter, who I assume was working part-time to fund his PhD program, started counting my tickets. I was now convinced of his doctorate aspirations as he finished counting faster than I was expecting. Then he looked down at me (literally and figuratively) and broke the bad news while pointing at the frivolous stuff in my hand that I had just purchased a few minutes prior, “Son, you HAD enough.

arcade tickets 2 not enough

I dejectedly went home without a giant teddy bear for my sister.

If you think about it, what we do today as adults is not that much different than what we did as kids. Instead of going to the arcade to earn tickets (using the venture capital from our parents, of course) we now go to place of work to earn money. Even more similar is how incredibly stupid we are in using our earnings.

When you consider the various components of our environment and how we interact within it, money is undoubtedly a major component. It turns out that despite its daily use, people still suck at understanding the consequences of their daily decisions.

How do you get people to quit sucking, you ask?

I think the most important thing to understand in behavioral finance (and life in general) is opportunity costs. Not just being able to explain it but more importantly being able to apply it in your decision making.

If you could just do that one thing, you would spend a lot of money on experiences that are important to you and very little money on unimportant things.

What do we usually do, though? The exact opposite.

Why is the application of Opportunity Costs so important?

Opportunity costs are what we are giving up by choosing one option over another. In other words, when we choose to go to the movie, we are also choosing NOT to read a book (or something else). The opportunity costs are the value and joy derived from reading a book that was not realized plus $15 for a ticket due to choosing an entertaining movie instead. Each day, we incur numerous opportunity costs of money and time.

opporunity cost 2

Although Opportunity Cost is extremely easy to understand in theory, it is extremely hard to apply in our decision making. This is especially true in identifying the opportunity costs of our money as it is very hard to visualize the tradeoff.

What else could I have done with that money? To answer that question, it would require a lot of time and energy to sit down and identify how that money could have been used to satisfy something other than what I actually used it on. What do we do when faced with this difficult task? Nothing.

Our decision making is irrational. Instead, what we should do is calculate what else we could have gotten, now or in the future, with that same amount of money and then compare the differences in our perceived value to see which option is most valuable out of those possibilities.

Envelope System – Generator of Opportunity Costs

Why am I such a fan of the Envelope System? It forces you to see opportunity costs.

Imagine the scenarios listed below:

Scenario 1: At the beginning of the month, you withdraw all the cash you will need for the entire month.

Scenario 2: At the beginning of the year, you withdraw all the cash you will need for the entire year.

Scenario 3: At the beginning of the year, you are given a credit card to use for the entire year.

Which scenario are you most likely to execute rational decision making through the application of opportunity cost?

cash envelopeI think we can all agree that Scenario 1 is superior to the others in this regard, and Scenario 3 is the worst. This can be explained by the difference in time horizons. We go from a very clear boundary of time to a very unclear boundary of time.

In Scenario 1 you may not pay much attention to the envelopes during the first week. But as the money starts to dwindle down, you have to start thinking about how that money is going to be used. Every time you buy something you realize you cannot buy something else because that money is gone and will not be replaced until next month.

It does not mean that you don’t spend money. It just means you have to think about how you are spending money.

As we move down to each of the three scenarios we start having to think about money less and less.

The paradox of Scenario 3 (using a credit card) is that although it is convenient, the time horizon is too convoluted and the fact that we are one step removed from cash literally makes it impossible to feel the tradeoff being made. The tradeoffs are so unclear that we don’t even think about it, even if we do payoff the balance at the end of each month.

This explains the person we all know who is incredibly diligent in their daily spending but sees no problem in having consumer debt, student loans, 30-year mortgages, financed cars, and so on – the time horizon too unclear for them to care.

If we look at which scenario best replicates the current financial environment in which we live, we see that Scenario 3 is widely accepted despite its ability to make us terrible decision makers.

A real life example – the 30-Year Mortgage

I don’t think there is a more glaring example of our inability to understand opportunity cost than the question, “Should we get a 30-year mortgage of a 15-year mortgage?” Each has its costs and benefits that we could calculate if we were willing to take the time.

Just knowing that there are going to be costs and benefits of each is not enough. What’s important is that you truly understand how to calculate the costs and benefits. Without that understanding, we cannot expect ourselves to make a rational decision.

Mortgage

As you can see in the above calculation using realistic assumptions, there is a difference of $146,000 between a 30-year and 15-year mortgage of $300,000. To put into plain English, a person bought a $300,000 house and was so grateful that the bank gave them a 30-year mortgage that they decided to give the bank $446,000 for a $300,000 house to show their appreciation.

Do people really enjoy giving the bank an extra $146,000? No. So why do they do it?

I think there are two reasons. First, people are much more willing to focus on the first monthly payment than they are the 360th monthly payment. The $643 not paid this month means a lot more than a $146,000 paid later. The lower payment means a more expensive house.

question 2Second, and more importantly, that $146,000 in opportunity cost is too abstract.

Yeah, $146,000 sounds like a lot of money, but what would we really do with it? That would require a lot of thought. So what do we do? As I said previously, we do nothing.

I’m not saying that a 15-year is better than a 30-year mortgage. The problem I am trying to address is how we are looking at the differences between the two.

If I went up to a 100 people with 30-year mortgages and asked them what they gave up in choosing the 30-year over the 15-year, all 100 would look at me like I had two heads. “What do you mean, ‘What did I give up?’ I got a house.”

If they made a rational decision, not one on pure emotions, they would immediately be able to tell me a few things that they gave up because they should have asked themselves two questions in deciding:

  1. What else could I do with that $146,000?
  2. And then, what is going to give me the most pleasure?

They may have come to the same conclusion, but at least they didn’t just wander into a 30-year mortgage because they were afraid to think.

As a quick example, let’s walk through a very simplistic exercise that everyone should use. (Bear with me as this exercise in a real situation would take weeks of thought, and I did it in just a couple minutes.)

Question 1: What else could I do with that $146,000?

30 vs 15 oc calc

Question 2: What will give me the most pleasure?

Right now, I would go for the Qdoba (I didn’t eat breakfast). In reality, I cannot say for sure which option we would choose, or even if those options listed would be used in the decision making process.

But what I can say is this exercise is vitally important to consistently making rational decisions on how we manage money. We should be thinking about these tradeoffs and how they will impact our life on a daily basis; from grocery shopping to buying a house, from which car we drive to which college we attend, and so on.

As a matter of principle I want to make something clear: I do not think that choosing between a 15-year and 30-year mortgage is as simple as I made it out to be in this post. There are a multitude of variables at play that make it a very complex decision. In fact, the house I call home is financed through a 30-year mortgage. When Megan bought this house she did what everyone else was doing – buying the most house that she could afford. The 30-year mortgage is indisputably more attractive to young people.

yes and noWill our next house be financed with a 30-year mortgage? Probably not, but I can’t say for sure. But what I do know, and what I am trying to get across, is that our next house will be purchased with a much clearer mind, taking present and future needs/wants into consideration. We will acknowledge our decision to say “Yes” is also a decision to say “No”.

The Real Question Financially Fit People Ask

This is where it’s important to recognize where we fall on the Broke to Fit spectrum. One end of the spectrum asks an entirely different question than the other side. People are not in the same stage of life unless they are on the same side of the spectrum.

b to f

There is unfortunately a stigma that is attached when someone starts to properly manage money and their behavior with money. When people find out that you pay close attention to your personal finances, they will immediately look for ways to confirm their suspicion that you’re a miserable cheapskate.

Don’t get me wrong, there is a time to be cheap. This would include anytime you’re on the broke side of the spectrum.

But that should only be temporary. The rest of your life should be spent on the Financially Fit side of the spectrum. We need to get to the other side as fast as possible.

However, Financially Fit people ask a very different question than broke people. They are not concerned with how to save more and spend less.

What is the real question a Financially Fit person would ask?

Am I optimizing the use of money and putting it towards the things and experiences that derive the most happiness.

If, for example, it’s the extra interest you’re paying on a house, then fine! But if it’s not…then change something!

Question: How do you analyze opportunity cost? Leave your answer in the comments section below!

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8 Comments

  1. Excellent coverage of the topic of opportunity costs. Typically in the business world it is evaluating the overall return of one asset against another from a financial perspective. The same can hold true for our personal finance decisions, however it get more complicated in that we might be comparing a mortgage to perhaps taking a nice vacation each year. That is when you have to really get in touch with what is important in your live. 🙂

    Regarding the envelope system: I am a big fan. For those of us who use this tool, it really makes you consider all of your purchases carefully. When you know that there is no more money in the budget when the cash is gone, definitely changes your buying habits. Whipping out a credit or debit card moves the emotional impact to a later date and makes it far too easy to over spend in the present moment.
    Bryan@Just One More Year recently posted…Should you rent or buy your home?My Profile

  2. Great coverage and description of opportunity costs. My approach, with respect to retirement planning and money – the primary focus at this point in my life – is similar to Hannah’s in that I don’t think in terms of analyzing various options for expenditures as the distribution of my income is largely on auto-pilot, based on a plan developed long ago, and managed/monitored regularly. My approach to what to do with my time (a valuable resource) – when I’m not working the 9 to 5 job – is largely ad hoc. If I’m working on my blog and my wife suggests joining her as she walks the dogs, the decision to go or not go is not analyzed too deeply and certainly not from a financial perspective.
    SavvyJames recently posted…Living Frugally: Getting Off Track – It Happens to All of UsMy Profile

    • Hey James! You’re exactly right. I understand completely. Could you apply this analysis of opportunity costs to every decision? Sure…but you’re life would be miserable.

      Auto-pilot is by far the best way to allocate your resources. But someone has to set up that auto-pilot – and they better realize their is a tradeoff with every decision. Or they would be in for a rude awakening 🙂 Thanks for stopping by!

  3. Analyzing opportunity cost is so difficult that we don’t even try (except when buying a property). Instead we try to create a hierarchy of wants that is as in line with our true selves as possible. Our hierarchy consists of giving, tools, opportunities and luxuries.

    We always give to charitable causes first, otherwise we would forget, but that’s just us. Then we spend on tools that help us solve our daily problems (need to eat, need to live somewhere, want to fix the house, etc.), then we save or invest to help us create opportunities (either to solve problems or do whatever we want in the future), and then we indulge in luxuries with what’s left.

    To this we’ve added one small legalism which is that we don’t take on any debt at all because that skews our perception of opportunity costs by introducing risk.

    • I think that’s everyones philosophy – don’t try 🙂

      I like what you’re doing. By setting up a hierarchy you are setting up a process where you acknowledge our limitations in intertemporal choice. I.e. you’re able to put today’s decisions in context of tomorrow’s need/wants/desire. “If we only have so much, this is what we’re going to do…”

  4. Drew H

    Good stuff Luke.

    I think the 15yr – 30yr mortgage debate is a great example of how the decision making process reveals a lot more about your financial responsibility than the ultimate decision you make. I am all for 15yr mortgages but just because someone happened to blindly pick a 15yr doesn’t make them more financially responsible than the person who weighed both options thoroughly and decided a 30yr mortgage made the most sense for them.

    Person1: Financially irresponsible with a 15yr mortgage. Has $146,000 extra to be irresponsible with.
    Person2: Financially responsible with a 30yr mortgage. Has $643 extra a month to be responsible with.

    Ill take Person2 any day.

    Again, I’m all for the 15yr mortgage and have one myself. It made the most sense for us. I’m much more pleased with the steps we took to make the choice than the actual choice itself.

    • Wow…that is said amazingly well!

      This explains perfectly my reluctance to follow and share “How-To” ideas. There are a lot of how’s. Instead, I want to follow and share “What-To” ideas. It prioritizes the beginning of the process, not the end. Our actual decisions are far less important than the steps we took to get there – and whether or not we even realized how we got there. Decisions come and go. But how we came to those decisions is often the same across various areas of life.

      Thanks for the insight, Drew!

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