Every day people make financial decisions that significantly affect their ability to build wealth over time and become financially secure. Unfortunately, these decisions aren’t always good ones, but they can be easily avoided if you are aware of why that is. First, you must understand how opportunity cost in a personal finance context applies. It is simply what an individual forgoes in preference of another good, service, or investment.
In a perfect world, we would always maximize our financial choices, invest in the best-performing stocks, buying at lows and selling at highs, never paying interest on credit cards, etc. However, individuals seldom maximize their choices for a variety of reasons. Case in point is that if you think of a purchase or investment in terms of opportunity cost it can help you limit some of the bad decisions, and capitalize on the good ones. What could my money be doing INSTEAD of buying this product, INSTEAD of paying interest on this credit card, INSTEAD of holding this cash? If you remind yourself of these questions frequently, you’ll have a better grasp as to whether you’re making a smart decision or not.
Below are 5 of the worst financial decisions you can make according to opportunity cost that I think everyone should be aware of.
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Buying a New Car
Cars provide high utility for people who love cars, and there’s nothing wrong with that. However, it’s one of the worst financial decisions you can make from an opportunity cost perspective.
Source: How Fast Does A New Car Lose Value
A commuter car is likely to depreciate around 19% in the first year of ownership! If you think of a car as an investment, it’s easier to avoid this pitfall. Rather than buying a brand-new car, if you can find the model you want that’s a year or two older, you’ll get it about 19% cheaper.
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Paying Interest on Credit Cards
The interest that is applied to the balance of your credit card after missing the minimum payment is the same as paying a fee to pay off your balance at a later date, which is also the same as throwing away money. Yes, it’s that bad. People run into this problem because they spend money they don’t yet have or run up a balance so high that it can take months to pay off. Automate your payments, stick to a budget or spending limit on your cards, and you won’t find yourself having to throw away money.
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Holding too much Cash
I know this one is a little counter-intuitive. You can’t hold too much cash right? Well, according to opportunity cost, yes you can. Especially if you’re expecting to hold the cash over a long period of time. Historically, cash as a growth asset has not fared well over the long run, and when you account for the purchasing power loss due to inflation, the growth is almost non-existent. Investing the cash, even into other conservative investments that could yield interest or provide appreciation, is your defense against inflation. Holding cash for over a short period of time does no harm, but when you extrapolate that over 10-15 years and account for inflation, your cash could potentially purchase less than it could have 10-15 years prior due to inflation.
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Paying High Fees on Investments
Fee’s have become a focal point for investors over the past several years and rightfully so. Over time, they eat into your gains. The legendary value investor, Warren Buffett, challenged a hedge fund manager that an index fund would outperform a fund of hedge funds over ten years starting in 2007. So far it looks like Buffett is all but guaranteed to win. Here’s a visual at the end of 2015.
source: yahoo finance
Buffett, in his latest Berkshire Hathaway annual letter (which we highly recommend reading for business minded individuals) reveals the following:
After nine years, the index fund has registered a compounded annual increase of 7.1%, compared to an average of 2.2% for the five funds. In total gains, the index fund is up 85.4%. The average gain of the five funds is 22%.
85.4% compared to 22%, that speaks volumes. While hedge fund managers are known to be extremely intelligent, and skillful investors, they are hamstrung from the beginning by the fees they charge. The opportunity cost of an investor who had invested in a hedge fund vs a basic index fund is the difference between the returns over the ten years. Low cost, mutual funds, ETF’s, index funds, or individual securities traded on a low commission platform will ensure the majority of your money will go to work for you.
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Trying to Time the Market
Trying to time the market is a fool’s game. If a professional ever says differently we’d suggest you look for a second opinion. There are too many variables that go into the day-to-day, month, and year-long markets for someone to predict accurately, and consistently. As time goes on the markets will only get more efficient as technology’s ability to process information gets faster and faster.
Let’s use the 2008 great recession as an example. According to J.P. Morgan’s most recent Guide to the Markets, as shown on page 4, the S&P 500 from 10/09/2007 to 03/09/2009, had a cumulative loss of 57%. From 03/09/2009 to 03/31/2017 it had a cumulative return of 249%. If at any point in the downturn or upswing you decided to sell part or all of your invested assets, you may have missed a significant portion of the rebound as well as any gains thereafter.
It’s extremely rare to be successful and consistently sell at the high and buy at the low, otherwise, everyone would be doing it. This is the opportunity cost of trying to time the market, and in the case of 2008, it was significant for investors who decided to sell. You’re better off remaining invested for the long haul and adjusting your allocation to be less risky if you need the money in the near term.
By applying your understanding of opportunity cost to your personal finances, you’ll be able to make better financial decisions and avoid these 5 potential pitfalls.
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