Consider the Opportunity Cost of Every Investment
Much of our thinking about money revolves around profit: I invest x to get y percent profit in the long run; I will buy this sofa because it will decorate my apartment and make me happier. But when it comes to financial decisions, it is also important to consider what you are going to give up.
Because we are human, we make impulsive decisions all the time. But instead of rushing to decisions or just moving, really thinking about what we’re giving up when we make those decisions is a way of looking at our finances in the long run, not a short-sighted look.
Jonathan Clements recently shared this on his HumbleDollar blog:
Even if we ask about a possible trade-off or what economists call opportunity cost, there is no guarantee that we will make the right choice. Often it’s just too tempting to act on our first impulse. But at least asking the question makes us think about the problem, even briefly, and perhaps we have the courage to weigh the alternatives – and perhaps even invoke the willpower to choose a different path.
But that goes far beyond whether or not we should shop after a busy day. This is something to keep in mind when making any money-related decisions. Clements writes:
For example, if we invest a lot of money in a new mutual fund, we may find ourselves too dependent on one part of the market, especially if our new fund has the same authority as others we already own. If we buy a home , we may need a larger emergency fund to cover any incidental expenses and possibly additional life insurance so that our family can pay off our mortgage if we die. If we quit our jobs to start our own business , we may have to buy our own health insurance and possibly also purchase disability insurance.
This is something that has been especially relevant in my life as I struggle with how to pay for a one-room apartment in New York. Intellectually, I know that I will have to sacrifice other luxuries that I have become accustomed to over the years, and that this will be something of a hindrance to my other financial goal – the accumulation of my liquid savings. But there are other questions to consider, according to Clements: How will this decision affect my happiness? What are the risks? Do I need to make any other financial changes? What additional costs do I disregard?
This is by no means a new concept – we’ve written before about pushing the pause button and setting a rule for yourself before buying something – but it applies far beyond the realm of impulse spending. Any financial expense means you are ditching something else, be it a properly diversified portfolio or employer-sponsored health insurance. You must enter these types of decisions with a clear head and an understanding of what you are potentially sacrificing. As Clements writes, not every decision we make affects all of our finances, but “these echoes can haunt us over and over again, so this is a very important point.”