Opportunity cost is something really easy to overlook but extremely expensive when you do. In fact, in the following examples of opportunity cost you’re going to see how these financial mistakes might be the costliest mistakes of all. What’s treacherous about this is that the people making these errors rarely see it coming.
What is opportunity cost?
Assume say you have a choice to make. You can only select one of two alternatives – A or B. Let’s say you go with option A. Opportunity cost is what you could have gained had you made the other choice. Let’s take a look at a few real life examples.
Let’s keep it simple. Assume Janice can either go to college or continue working. The opportunity cost of going to college rather than staying at her job is the salary, job security, experience and career advancement she would have if she continues working.
This is not to say she should skip college. There is an opportunity cost to not going to college as well. Those opportunity costs are the jobs she won’t be able to apply for because they require a degree from college.
As you can see, this example illustrates the critical principal that every decision has tradeoffs and opportunity costs.
Let’s look at the opportunity costs associated with another important financial decision – life insurance. Say you know you need some life insurance although you aren’t quite sure if you should buy whole life or term.
The opportunity cost of buying whole life and skipping term is high. Whole life is so much more expensive than term. As a result you will only be able to buy a fraction of the coverage that the same dollars would buy had you gone with term. That might leave you woefully underinsured.
But if go with term, the opportunity cost is that you won’t have the savings component that whole life provides and/or the insurance may not be in place if you die after the policy matures.
I’m not going to debate the pros and cons of term vs. whole life now. I am just trying to illustrate the second principle of opportunity cost and here it is; since every decision has a tradeoff, you have to prioritize in order to make a smart decision.
In the example above, if the priority is to have lots of life insurance at the least possible cost, you go with term. If you need an investment option, term is still probably better because the costs of whole life are so high. The only time that whole life makes sense is if you need it no matter when you die. Most people don’t have that requirement. But some people do have that need and for them, the opportunity cost of buying term rather than whole life may be too high.
The Take Away
The first lesson is that nothing is perfect. Everything has a cost. You always give up something when you make a choice. Get clear on what those costs are. Ask lots of questions and don’t stop asking until you are sure you understand. The second principal is to prioritize what is most important to you before you make a decision.
When was the last time you consciously considered opportunity cost when you made an important financial decision? What was your process? Did you end up with the right decision?
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