Even Opportunity Comes With a Cost
April 6, 2016 | Your Finances
Imagine what would have happened if Bill Gates and Mark Zuckerberg had not dropped out of Harvard.
They would have taken the opportunity to earn an Ivy League college degree. But Gates might not have co-founded Microsoft, and Zuckerberg might never have launched Facebook.
That would have been their opportunity cost, which is, simply put, what you give up when you choose one option over another. Most of life’s decisions—whether to attend graduate school or begin your career, buying a house and where to invest your money for the future, for example—have an opportunity cost.
Of course, it’s not always possible to know what the costs and benefits of a choice will be. And what’s right for someone else may not be the best decision for you. But it’s important to include opportunity costs in your decision-making process. Today’s decisions can have a tremendous impact on your future finances.
Take going to college, for example. Millennials are more likely to choose to attend college and graduate school than any previous generation, according to a report to President Obama by the Council of Economic Advisers.
Someone with a bachelor’s degree can expect to earn $2.1 million over his or her working life. Someone holding a master’s degree can expect to earn more, approximately $2.5 million, according to the U.S. Census Bureau.
For someone launching a career right out of college, the opportunity cost is missing out on the increased earning potential of an advanced degree. The opportunity cost of going to graduate school is giving up the immediate earnings from a job.
Whether we realize it or not, we all consider opportunity costs when deciding how to use our money. We know buying a house is a traditional way of building wealth and has tax benefits (you can deduct mortgage interest and property taxes from federal income taxes). Each monthly payment reduces the amount you owe, and the value of your home may increase over time. But you may value the freedom that renting gives you to move to a new city. We balance the opportunity and the cost represented by each choice.
That’s true when investing, too. Let’s say you have $10,000, and your choice is to buy shares in company ABC or put the money in a CD earning 3 percent per year. If you buy the stock and get a 10 percent rate of return, congratulations, you’ve benefited. But if company ABC returns 1 percent, your opportunity cost is the additional 2 percent you would have earned with the CD.
It’s important to consider opportunity cost when making financial plans. Should you invest your 401(k) in stocks, which could bring a higher rate of return, or in bonds, which tend to be more stable? For someone investing in the stock market, the opportunity cost is the potential for your investment to lose value. For someone investing in bonds, the opportunity cost is losing out on the higher rate of return that stocks can bring.
Would you be better off paying down debt or investing? The opportunity cost of using your money to pay off a credit card or other debt is missing out on the potential growth of your investment over time. But investing can come with its own opportunity cost. If your investment yields 7 percent but you are paying 16 percent in credit card interest, you are losing money, not earning it.
When you’re making a choice, it’s important to look at both the opportunities your options provide and the costs that come with them—the things you’ll get and the things you’ll give up. There are often no right or wrong answers when making a decision, and evaluating opportunity costs might not make you the next Gates or Zuckerberg, but it will help you make more informed decisions—and that’s always a good thing.