Understanding Opportunity Costs
TLDR: You need to think about opportunity costs when it comes to your finances.
The words “opportunity costs” might sound fancy, but it’s really another term for the trade-offs you make. As in, what you gain or give up when making decisions with your money.
Your financial wellness boils down to your decision making process. And it’s not all black and white — a choice means there is both a gain and a loss.
Many people talk about opportunity costs in terms of business economics, but you can apply it to your everyday money choices. Let’s say you decided to spend $30 on a new shirt. Sure, you get a nice piece of clothing that rounds out your wardrobe, but that money could have gone to other things like drinks with friends or an upcoming Disney World vacation.
There is No Right Or Wrong Answer
The truth is that you can only make decisions you think are best for you at the time. You can look back in hindsight and see what you’ve gained or lost with every financial transaction you’ve made.
In my previous career as an elementary school teacher, I had the opportunity to go overseas right out of college. It sounded like a fantastic idea:who wouldn’t want to get paid to live and travel in another country, amirite?
But let’s break down the opportunity costs:
Pros (or gains)
- Travel long-term in another country
- Lower standard of living, therefore the ability to save more money
- Health insurance, housing and transportation paid for
- Plenty of learning opportunities — language lessons, living like a local in a foreign country
Cons (or losses)
- It could be hard to advance in my career when I move back
- Could experience homesickness — aka miss family and friends
- Extra disposable income could mean getting used to a higher standard of living
- Lower salary
Eventually, I did go overseas for many years after looking at what I would gain, as well as give up. While I did experience lifestyle inflation and had to make the transition moving back, it was worth it for me. The increased opportunity for savings and getting to travel on a budget helped me become debt-free and grow my budgeting skills.
How To Calculate Opportunity Costs
There is no clear cut formula to calculate opportunity costs — it’s completely personal. Like in my life example with working abroad, it came down to with what I was willing to sacrifice or give up. You need to consider your values and feelings, even when making financial decisions. Think about what you enjoy doing, or some of the best ways you’ve spent your money in the past. Do you value security for your family? Adventure?
Break your money-related decisions down into pros and cons, or what you’ll gain or lose as a result of your choice. Laying these consequences out in the open allows you to stack them up against your values, just like what I did with my career choice.
Of course, you don’t need to do this with every single spending decision — like, “Should I get an extra mimosa at brunch?” or, “Should I pay the extra $5 to get groceries delivered?” In these cases, ask yourself simple questions such as, “Is spending money in X in line with my values of X?” or, “If my priority is X, is this decision moving me towards or away from it?”
At the end of the day, you don’t want to drive yourself crazy thinking of all the money you could have saved or made if you made different decisions. The goal in thinking about opportunity costs is to help you make a more mindful decisions with your money. It can help you stop second guessing yourself — think of opportunity costs as a guideline every time you’re unsure whether to save to spend that money. It’s a tool for you to use whenever you need it