“I think life is a whole series of opportunity costs. You know, you got to marry the best person who is convenient to find who will have you.”
–Charlie Munger
When asked about how to get rich:
“We get these questions a lot from the enterprising young. It’s a very intelligent question: You look at some old guy who’s rich and you ask, ‘How can I become like you, except faster?'”
— Charlie Munger
A READER QUESTION
A younger reader asked about this subject and how to evaluate opportunity cost.
Here is the question:
“You have $5,000.
You could put it in the bank as a safety net. You could invest it in stocks. You could use it to start a small business (like the questioner did). You could use it to invest in your education/growth. You could use it to travel.”
“What is the best choice?”
He pointed out that he decided to start a small business and invent his own board game, not invest the money or create a safety net. And along the way, he learned a lot about business and the creative process. He concluded creating the game was a better use of time than taking his savings and investing them for the next 50 years.
He may be right.
It boils down to a complex but practical question. Should we take one path or another? Which will help us the most? Did the reader make the right choice or not?
Evaluating opportunity cost is one way to answer the question.
DEFINING OPPORTUNITY COST
Opportunity costs are the value of the next-best alternative when a decision is made. Put another way, it is the cost of what is given up.
Ideally, the choice you give up is worth less than the choice you make.
THE THREE READER QUESTIONS:
The reader is really asking:
- How can I be sure that my decisions will likely result in material wealth?
- What should I be doing when I make individual near-term decisions and want to evaluate them through the lens of opportunity cost?
- When I make more significant decisions about my life, what are all the issues I should be looking at, and how do I use an opportunity cost analysis to evaluate them?
The first answer is obvious. You should read this blog.
Just kidding.
However, I will try to give you information so you can make your own best decisions. And I try to do it without bias.
Decision-making is a process, and no one approach is always the best way to look at things.
The second question is well defined, and I hope to explore it in a future post. It involves direct financial analysis of various options.
The third issue almost is a little like wishing you had your own Decision-O-Meter that could tell you about choices like: did I marry the right person, or was the one that got away better? Did I make the right job choice in doing what I love or settling for a job with security?
A FEW OTHER CONTEXT OBSERVATIONS
So, it is easy, right? You choose one action or the other, and whichever pays more is the best. The opportunity cost you have given up is less than what you choose.
Of course, it is not that simple, especially for a long-term decision. Here are a few context aspects that must also be considered:
- Where you are in your life cycle—if you are older, can you afford an action that can cost you everything? At some point, it is impossible to earn back that money.
Example: should you try to start a business in your 60s if a potential loss will damage your retirement?
- How much risk are you taking in pursuing an alternative—are you all-in or hedging bets? What percentage of resources are at risk for an option?
Example: will starting that same business in the example above potentially damage you if it fails and you only invest 10 percent of your net worth versus 50 percent?
- Short versus long term—how much could your money compound if you invest it versus spending it all now? For instance, traveling and seeing the world?
Example: the reader asked about investing $5,000 instead of spending it inventing and marketing a board game. How much would investing his money have earned instead?
The exact amount is impossible to say. But compounding is a consideration in any financial decision you make. One of the points Warren Buffett emphasizes is that over a long period, investment gains can be considerable. For example, at age 11, he invested $114.75 in Cities Service stock. And later, he sold at a small profit.
In his Jan. 31, 2019, annual letter Buffett talked about compounding and what could have happened instead. He used a theoretical example. Suppose he had invested the same money in a no-fee S&P 500 index fund, one that automatically reinvested all dividends and just held on, making neither additions nor withdrawals. (And remember, this is just an example. The first index fund did not exist until the mid-1970s.) The amount: $606,811. So, consideration of compounding matters.
- Your aptitude– is a hard one because, with practice, especially 10,000 hours of practice, you will get far better and even become an expert. So, determination and hard work matter for success.
But raw talent and circumstance matter too. For instance, I can’t become a professional basketball player. I do not have the talent and am much too old.
- Ability to keep healthy—is how you spend your time keeping you safe or not? For instance, a job cleaning toxic waste dumps is riskier than being a Certified Public Accountant (CPA).
THE USUAL LONG TERM OPPORTUNITY COST CHOICES
There is no one answer to spending time and maximizing financial security. However, over a lifetime, certain behaviors seem to pay off. Here are a few examples that have been covered in MMH before. Here are the questions I have tried to analyze:
- Getting an education or not? In one post, we explored this subject. College graduates make about $1,000,000 more over a lifetime than non-graduates. Net worth is also higher, with about 85 percent of millionaires being college graduates.
But note that the person who asked the question brings up a great point: education can mean many things, not just going to college. It can be an experience that makes you uniquely valuable—like starting your own business. It can be training for a skill for the same purpose.
- Buying a house or renting? Buying. See the post here.
- Getting married or not? Generally, this is a significant financial positive—if the marriage lasts. However, divorce is also a leading cause of bankruptcy.
CONCLUSION
The reader asked a practical question. How should we make decisions? What is the optimal path to take to achieve financial independence? And how do you find that out?
No one approach works in all circumstances. But considering opportunity cost is a logical way to proceed and is a valuable tool. However, consideration of other issues is essential too. The process is:
- Think about context: consider what your situation is.
- Consider timing: think about the short- and long-term implications of your decisions
- Evaluate opportunity cost: how valuable is what you give up in time, money, or other resources.
- Research your options and find out about the experiences of others. Some long-term decisions are more likely to succeed than others. It is essential to know what those are. You don’t always have to act and then determine the implications. Use the experience of others.
Disclaimer: consult with a financial fiduciary before taking any steps outlined here. Not all advice may be suitable for your circumstances or investment style.