When we talk about saving money and optimizing costs usually we talk about how much something costs. Usually these are hard costs like it costs you 10 dollars for that six pack of beer or 4 dollars for a coffee. But in reality cost comes in to play beyond what you actually pay for something. Opportunity cost has to be added into the impact of any expenditure on your financial decision making process.
What is Opportunity Cost?
Opportunity cost is the concept that in order to purchase or even do something you forgo something else. So a clear example would be expenses versus savings. If I spend my money on a new car then the cost of the car really equals the actual cost of the car plus the interest I would have earned by investing that cash.
Some bloggers even utilize this simple concept as a psychological crutch to help keep their lifestyle inflation in check. They will look at the cost of an item as the cost plus how much it would be worth in retirement. Then they will use that cost to determine if the item is really worth it to them based on how many weeks of “freedom” it provides them. That’s a very rational financial approach that will lead to a better mathematical result if you prioritize retiring earlier.
Non Monetary Opportunity Cost
Not all opportunity cost is monetary though. Take my trip to Martinique. It cost me almost nothing after travel hacking to go, but there was still a cost. I could have used those points to go somewhere else. I could have also used the time to go somewhere else. Those other opportunities are also opportunity costs to be considered.
We’ve written in the past about the risks of spending too much time saving money. In that post I referred to looking at the value of your time versus the amount of the savings. This is again opportunity cost in action. If I spend an hour clipping coupons to save 20 dollars on groceries we have to ask could I have earned more then 20 dollars with that hour utilizing it for a side hustle. Or could I use that to spend quality time with my kids. How would would time with my children be valued versus coupon clipping. Life is obviously about choices and opportunity cost plays a part in that calculation.
The Problem with Opportunity Cost
The big problem with opportunity cost is what it can do to your decision making process. Simply put it can cause Analysis Paralysis. There are an infinite number of alternative opportunities to what you are doing at any moment. It’s quite easy to go down a rabbit hole of considering alternatives.
Take my travel example. I could go to the Caribbean and have a fantastic time, or I could go to an infinite number of other locations. I could use the money to offset regular spending so I could invest more. After all money is fungible so if I used other cash to invest and this cash to pay bills it would be like saving this money. The sky is the limit. The problem is that means your opportunity cost is infinitely complex to calculate in some cases. Thus you could be paralyzed and not be able to make a decision.
An Approach to avoid Analysis Paralysis
The first thing to be clear of is that Analysis Paralysis is essentially a type of decision. Not making a decision is a decision. You’ve chosen to not make a decision. Meanwhile, the time you spend making that decision also has a cost. As such you do not want to do infinite cost calculations on alternatives or you’ll end up eating up any savings by choosing a cheaper alternative.
The best approach therefore is to limit the alternatives you are considering. In my case I only consider those alternatives I would realistically execute with those funds or time. So if I plan to spend 3 weeks a year on vacation, my Martinique decision is only a question of Martinique and other vacation spots for a given week. Within vacation spots my options were only those within a distance my kids could tolerate on a plane, a warm weather location since it was February, and where I could realistically pay for it with travel hacking. The ability to whittle down my alternatives quickly allows me to make a quick decision. So the key here really is to only analyze the appropriate decisions and quickly throw out other options.
Sure there is some risk to this approach. You could automatically exclude a better opportunity. So for example a number of personal finance bloggers have made it a point of stressing you can live without a car. It’s easy when contemplating which new car to get to completely overlook the ability to live without a car at all.
They have a point, with a but… The but being like anything else you should be contemplating car or no car independent from the decision on which car to buy. You should do so before it’s time to make a decision on what car to buy. You need to remove the emotion of that question from the decision by considering the question of car or not before deciding which car to buy.
The key here is to break up decisions into bite size questions with a limited number of options. Deal with a few options at a time, make a decision, and move to the next one. This limits the amount of time to make the decision and the potential for Analysis Paralysis. You do still need to keep an eye on the long term. To do this ensure each individual situation is in line with your long term plan. But tackle the gnarly questions a piece at a time to be successful.
I would be remiss in not pointing out that answering too many questions has been proven by various studies to degrade the quality of your decisions. This is called decision fatigue and is a very real phenomenon where making too many decisions can lead you to not analyzing a decision appropriately for impact. Biting your questions into smaller chunks does increase the number of decisions you make, so there is a concern here.
However again the problem can be mitigated. Automating some of the lower impact decisions can go a long way to decreasing the number of questions you have to answer. So for example automating some of your savings or investment choices can remove those questions from your decision list. Doing so frees you up to split the gnarly problems into smaller bite size pieces and solve them.
How do you manage the decision making process? Do you account for Opportunity Cost? Do you break decisions down?