Many times, the biggest obstacle to effective financial planning is the lack of understanding opportunity cost and the impact it has on personal finance. In order to take advantage of an opportunity, something else must always be given up.

What is Opportunity Cost?

Opportunity cost is basically what you lose by choosing one opportunity and giving up the next best choice. For a basic example, let’s say you can choose between going out for dinner or putting R200 in savings. Each choice has benefits and draw-backs. If you choose the meal, you will likely have a good time, eat good food, and get a chance to relax. If you choose to save the money, you give up that good time and good food, but you get the chance to earn interest on that R200, giving you more money in the future. Either way you stand to gain something and lose something: gain a good time, lose the interest that R200 could have earned. Gain interest on R200, lose that good time. Every time you make a choice, you’re weighing the opportunity cost of that action.

The importance of Opportunity Cost

Opportunity cost is even more important when you face big financial decisions. Rent a home or buy one? One comes with the potential to gain value as an investment, but it also comes with added responsibility and expenses. The other will not gain value but will require less time and money over time. Your opportunity cost here is the loss of potential investment gains if you rent versus the loss of time and additional money you incur if you buy.

Go to university or go straight into the workforce? One will be very expensive, but will hopefully yield higher earnings over time. The other choice lets you start earning money immediately, but you may come to a point where your earnings cannot in-crease without that degree. Your opportunity cost here is the loss of potentially higher earnings if you go to university versus the four years of additional income you will make if you don’t go to university. In any situation, which one you choose depends on how much you value the opportunity that you choose versus the one you must give up.

Think about it!

Normally all this goes on unconsciously. You may get out paper and pen and make pro and con lists when faced with big choices like buying a home, starting a business, or going to university, but most of our day to day decisions aren’t made with a full appreciation of opportunity cost. We just look at our current account, see that we have money and buy the new shirt or go out to eat. We don’t think about the things that we must give up when we make those decisions. In fact, most of us aren’t even aware that we are giving anything up. If the money is there, it must be for spending, right? Anything else that that money could do for us seems so far in the future it doesn’t register.

Looking ahead

This is where financial problems begin. Sure, some-times you just really, really want that particular shirt or handbag. And it’s okay, within reason, to give in to those desires occasionally. If you’re certain that the handbag or shirt is worth more to you than the interest you could earn, the investment you could make, or the other things you could do with that money, then you’re making the decision that’s right for you. Sometimes the things you want in the here and now are worth more to you than future earnings or purchases. (Although you might not see it that way in ten years, but that’s another story.) And that’s okay. If you only look toward the future, you’ll miss out on a lot of things that are fun in life today.

Considering options

The problems begin when you never look at what else you could do with your money. When you buy things blindly or make big life decisions without considering the opportunity cost, you’re likely to find yourself making decisions where the opportunity cost doesn’t come out in your favour. Let’s say you decide to buy a home. You’ve considered the pros and cons and you decide that the potential upside of buying is worth more to you than any upside that renting could bring. Great. So you start looking at houses. You decide to buy one that’s about R500 000 more and several square metres more than you originally planned on. The bank may give you the money, so it’s no problem, right? You know that buying is the better choice for you, so you get ready to make the purchase.

Stop. Consider what you’re giving up if you choose that bigger, more expensive house. You will be giving up lower utility bills, lower monthly payments, lower insurance costs, lower taxes, and lower maintenance costs. You might be giving up the chance to pay off the bond in ten years versus twenty, which could save you tons in interest and give you the chance to do even more with your money. The bigger house will give you more space and possibly a larger investment return, but are those potential upsides worth more than the other additional costs you will incur? You may decide that indeed they are and go ahead and buy the bigger house. Or you may decide to go with a smaller one. Either way, awareness of the opportu-nity cost of the choice you must give up will generally yield better financial decisions than making blind assumptions.

Self discipline goes a long way

It sounds like a drag to think about opportunity cost every time you want to buy a chocolate bar or some shoes, doesn’t it? But that’s exactly what you have to do in order to make the best use of your money. You cannot go through your financial life on auto pilot, assuming that the choices you make today don’t have costs in the future. You have to under-stand that when you purchase one thing, you are giving up other choices that might have been bet-ter. While you can’t know everything that will hap-pen in the future, you can have a good general idea of the impact your choices will have.

The good news

It only gets easier! Once you practice being conscious of the opportunity costs for awhile, it be-comes easier and more subconscious. You don’t have to actively think about the trade-offs of your choices as much. You will eventually be able to make decisions that take those costs into account without it being a big production. And that’s when your financial life will start to take off.

Make the right money choices, select your “opportunities” carefully, and you will not only control your wealth but grow it.

Keep in mind that opportunity cost is a function of time. Holding on to an underperforming investment for months or even years can lead to much higher opportunity costs, as can the deci-sion to lock in to a low return over a long period of time.

Opportunity cost in investing should be viewed through the lens of your personal financial situa-tion. Would you be better off paying down debt? If an investor earns a 6% yield on an in-vestment but is paying out 18% annually in credit card interest, that person is in fact losing money, not earning it.