When it comes down to personal finance, one economic principal rules the roost - opportunity cost. With more household incomes stretched to the limits in the wake of the global economic slowdown, this principal is quickly becoming a budgeting essential. However, the rule doesn't just affect what we spend our money on - it also dictates much of our personal finance lives. From our careers and our individual housing situations to how we invest and where to go to school, understanding the opportunity costs concerning these decisions is key for a sound financial footing.
While most people are aware of the direct costs of life - for example, when you take money out of your wallet to buy a cheeseburger - many ignore the indirect costs associated with those actions. These are the opportunity costs. At its core, an opportunity cost is what you lose by choosing one alternative over another.
Now, let's say you can choose between eating the aforementioned cheeseburger meal and putting $4.50 into savings. Each choice has benefits and drawbacks. If you choose the burger, you will likely have a nice lunch and a chance to leave the office. If you choose to save the money, you give up that break time and good food, but you get the chance to earn interest on that $4.50. That will give you more money in the future. Either way, you stand to gain and lose something. Every time you make a choice, you're weighing the opportunity cost of that action.
Opportunity costs extend beyond just the monetary costs of a decision, but it includes all real costs of making one choice over another, including the loss of time, energy and a derived pleasure/utility.
SEE: Economics Basics: Production Possibility Frontier, Growth, Opportunity Cost and Trade
Using Opportunity Costs in Our Daily Lives
For big choices like buying a home or starting a business, you may weigh the pros and cons, but generally, most of our day-to-day choices aren't made without a full understanding of the potential opportunity costs. If they're cautious about a purchase, most people just look at their savings account and check their balance before spending money. For the most part, we don't think about the things that we must give up when we make those decisions.
However, that kind of thinking could be dangerous. The problem lies when you never look at what else you could do with your money, or buy things blindly without considering the lost opportunities. Certainly, buying a cheeseburger for lunch occasionally can be a wise decision, especially if it gets you out of the office when your boss is throwing a fit. However, buying one cheeseburger every day for the next 25 years could lead to several missed opportunities. Aside from the potential harmful health effects of high cholesterol, investing that $4.50 could add up to just over $52,000 in that time frame, assuming a very doable rate of return of 5%.
This is just one simplistic example, but the basic message holds true for a variety of situations. From choosing whether to invest in "safe" treasury bonds or deciding to attend a public college over a private one in order to get a degree, there are plenty of things to consider when making a decision in your personal finance life.
While it may sound like a bummer to have to think about opportunity costs every time you want to buy a candy bar or go on vacation, it's an important tool in order to make the best use of your money. When it comes to personal finance, you cannot go through your life on autopilot. There are unseen positives and negatives with each financial decision. However, the good news is that once you recognize that these costs exist, it becomes easier to make good personal finance choices.
SEE: Understanding Compound Interest
The Bottom Line
Most people are aware of the seen costs when it comes to personal finance. We understand the direct costs for our actions. However, the unseen costs could be more important to realize. Understanding these opportunity costs is critical to making the best possible decisions with our money.