The first day of my (Tim) Introductory Microeconomics class our teacher provided us with a few key tenants surrounding microeconomics; 1) assumptions must and will be made (I still don’t agree with this principle and feel it can distort the real world – maybe it will be our next blog post), and 2) there is no such thing as a free lunch. The second point baffled me at first. I had heard of opportunity cost, but I had never truly sat down and thought of its real-life application. Our teacher began peppering us, attempting to see if we could break this fundamental rule. It is a difficult and an almost impossible task. Anything you do has another side of the story; as humans, we are constantly battling a zero-sum game. Opportunity cost is real and is a core tenant not only in economics, but in your financial plan as well.
Opportunity cost can be defined as:
“…a benefit that a person could have received, but gave up, to take another course of action. Stated differently, an opportunity cost represents an alternative given up when a decision is made. This cost is, therefore, most relevant for two mutually exclusive events. In investing, it is the difference in return between a chosen investment and one that is necessarily passed up.”
For example, let’s assume Bob, at his current job, makes $50,000 per year and would like to make a job change because he is unhappy. However, Bob can only find jobs where he will make $35,000 per year with the potential for raises in the future, but feels he will be happier at the other jobs. Bob is now surrounded by opportunity costs. From a salary point-of-view, Bob would be hit with a $15,000 opportunity cost per year. If we assume he does not receive a raise for five years, that would be a $75,000 opportunity cost over five years! Stated differently, is Bob’s happiness worth $15,000 year? Now, I understand this seems harsh and Bob’s happiness, to quote Mastercard, is “Priceless”. However, as harsh as it may seem, it’s reality. For example, what could have Bob done with $75,000 over five years? Had an earlier retirement? Helped support his children through their college years? Gone on an awesome vacation once a year? You can see my point – opportunity cost is real and makes financial decisions extremely difficult.
Inside our Bob example, there are few things going on if you were to look at it through an economic lens. We are attempting to find Bob’s utility for more money. Utility is described as:
“…a measure of preferences over some set of goods (including services: something that satisfies human wants); it represents satisfaction experienced by the consumer of a good.”
Essentially we are trying to gauge Bob’s happiness as it pertains to having less money, but a better work environment. Or, if being less happy at work and having more money is worth it. Simply put, we want to know what Bob truly values. This simplistic concept is the linchpin to financial planning. If an individual/family can truly understand what they value, their financial health and well-being is easier to maximize. Every decision can then be based on core principal tenants allowing you to optimize your money. For example, let’s say Bob truly valued travel, to the point that every trip he could go on would bring joy, that he felt, was truly “Priceless”. Knowing that, we can begin to make the optimal decision. Based on his feeling towards travel, one could argue that Bob should stay at his current job, allowing him to travel and maximize his utility. Understanding what you truly value allows you to take control of your dollar and begin spending it in a way that maximizes your happiness, regardless of what that might be.
If we were to achieve this level of understanding, the financial planning process becomes an easier road. For example, budgeting becomes less of a task. Let’s assume clothes make you happy and feel great, but your cable subscription and going to the movies is, well, blah. Now you know – cut your cable and stop going to the movies, freeing up cashflow for shopping. Furthermore, when hit with a large event such as a job change, increase or decrease in income, or divorce, the opportunity costs you face become simplified as you know where to start decreasing, increasing, or adjusting. With that said, what you value can change over time; if you recognize the change, then you can begin making the necessary moves to reach optimization. Understanding what you value can allow someone who makes $40,000 per year feel like the richest person in the world, as they can truly maximize the value of their dollar achieving what they truly want.
I recognize it is easy to sit here and write about how the secret to financial success is understanding what you value. It is not an easy task and it’s constantly changing, but I do have a real-life example to possibly help you figure out what you value. When I was roughly 10 years old my family went on vacation to Hawaii. I saved up all my money from birthdays and working with my Dad, and I was going to buy a souvenir. We got to Hawaii and seven days later, back in the LAX airport, I cried to my mom explaining how distraught I was that I didn’t buy a souvenir. At that point, I didn’t realize that stuff didn’t bring me happiness. Fast forward to my senior year in high school and a trip to California. Before my friends and I left, I had won a competition at school that layered my pockets with about $400. On our trip, I took that $400 and bought dinner for all my friends and didn’t even blink an eye. You see, I don’t value stuff, I value seeing other people enjoying themselves and I enjoy people’s company. This is where my dollars are spent, not because it’s cheaper, but because my dollar goes a lot farther when I spend it on experiences with others. If you can look back at your past and see where you felt the most joy when you spent your dollar and maybe a few times you had remorse, you can begin to understand what you value.
There is no such thing as a free lunch and this simplistic phrase unleashes a hundred different ways on how to look at spending money. It is difficult to evaluate every situation to maximize your dollar – you could go mad. However, taking the steps to understand that, 1) opportunity cost is real and is a constant battle you’re in, and 2) reflecting on what you truly value, will allow you to begin optimizing your money placing you in the driver’s seat of your financial well-being.
 In this example, I am not including taxes, benefits, time value of money, or other items to simplify the example. If you are currently in a similar situation, please note there are other considerations that need to be taken.
 For simplicity purposes, I am not taking into consideration diminishing marginal utility.