All financial decisions have consequences.
Ever wondered what would have happened if you had put your money into property instead of shares? Or if you had used your spending money to pay off some debt instead?
In a nutshell, this is referred to as the opportunity cost of saving money.
We explore whether saving is always the right option and the consequences of financial decisions.
What is opportunity cost?
Opportunity cost is an important factor in your personal finances.
Every financial decision you make will impact your future financial circumstances.
When you’re faced with different options for how to save or invest your money, the opportunity costs are the amount that you have to give up minus the return you get from your chosen investment. Basically, it’s the value that you will lose from choosing another option.
The formula to work out opportunity cost is: FO – CO
FO is the return or value of the forgone option and CO is the return or value of the chosen option.
What is the opportunity cost of saving money?
Let’s say you have $10,000 that you decided to leave in a savings account two years ago.
Saving has many benefits, from paying off debt to being able to afford large purchases such as a down payment for a house.
But how much interest have you earned over the past few years?
Today, the average interest rate for a savings account is 0.06%. Using this as an example, this means that your savings pot will have earned you nearly $12 over the two years. This is your real cost return.
Interest rates are at an all-time low so if you managed to secure yourself a higher interest rate, your return on investment would be more. For example, if your bank offered you an interest rate of 1.5%, your return rate would be $300 over two years.
To calculate opportunity cost, you need to compare your financial decision to another option, such as investing or spending.
Implicit costs are the costs associated with a financial choice. Investment fees such as transaction fees and load fees are both implicit costs that occur from your decision to invest money into something.
Explicit costs are payments made as a result of a business opportunity or investment such as people’s salaries, rent or lease payments, utility bills and raw materials.
What is the opportunity cost of investing?
Now, let’s take a look at what the opportunity cost would have been if you had decided to invest your $10,000 instead.
The opportunity cost will vary greatly depending on your investment opportunity, so here are a few examples.
Investing in property
Even if you don’t have enough money to buy a property outright, you can still tap into the real estate market with smaller funds in the back.
With a REIT (real estate investment trust), you can buy property shares that are listed on the stock market.
You can generate money from a REIT in the following ways:
- The property that you have a share in generates income through rent. All investors then divide the profits.
- If a REIT property is sold, the lump sum of cash is split between all investors.
- More REIT properties may be bought with the profits, resulting in a regular income for all investors.
Therefore, if you had a 5% share of a $200,000 REIT property that was sold for $250,000, you would receive $12,500. This would make your return on investment $2,500. In this example, the opportunity cost would be the difference between $2,500 and the profit you made from either saving or another investment opportunity.
Investing in the stock market
Instead of investing in real estate, you may decide to buy $10,000 worth of stocks and shares on the stock market. The average stock market return on investment is around 10% but factors such as inflation can affect this but it’s generally a much better rate than you would get from a bank account.
The key to making money from stocks and shares is to keep your money in them for the long term (at least five years). With stocks and shares, you are often faced with the decision of whether to sell your shares now or keep them and sell them at a later date. If you choose to sell them now, the opportunity cost is the difference between what you sold them for and what they are worth in the future.
So, using our $10,000 investment as an example with a 10% return per year, your opportunity cost for investing in the stock market would be $1000 per year. This makes $2000 over the two-year comparison period. If you’re interested in investing in the stock market, index funds are a simple concept with low fees.
Investing in Certificates of Deposit (CDs)
CDs can be a good long-term investment that provides a higher return rate than a traditional savings account. They are also FDIC-insured, making them a low-risk investment option.
So, how do they work?
You give a bank your $10,000 investment for an agreed amount of time, after which you will receive your investment back with a predetermined amount of interest added. The longer your loan period is, the more interest you will receive.
CD interest rates vary, however for this example we are using a 5% APY over a 5-year term length. After five years, the return on your original deposit will be $772.84.
Always compare CD rates to get the best return on your investment. Some CDs allow you to add to your investment throughout the term length, which will increase the return you get at the end of the agreement. If you need to withdraw your funds early you could be faced with a penalty, which will affect your return rate.
If you’re faced with the three investment opportunities above and chose to invest in property, the opportunity cost is negative because you make a bigger return on your investment. This means that it’s unlikely that you will regret making that financial decision. When it comes to investment opportunities, consider the return that you’re likely to receive for each option before deciding where to put your money.
However, if you had decided to put your money into a savings account, the opportunity cost is positive compared to both investment examples. Therefore, you will probably regret choosing the savings route.
The opportunity cost of spending
Even spending money has an opportunity cost when you have a choice of two items, which is referred to as comparison shopping. Price, value for money, features and product reviews are all considered when deciding on purchasing a particular product.
Let’s say you decide to spend $10,000 on furniture and appliances for your new home. What other ways could that money have been spent? If you had decided to use the $10,000 to add to the down payment for your house you would have benefited from taking out a smaller loan and saving money on the interest for your mortgage.
The opportunity cost of investing instead of spending
Another example of a negative opportunity cost would be if you had $4000 that you decided to invest in a share of a company. You begin to earn a profit on your share, however, you missed the opportunity to pay off a high-interest debt that you have which would save you more money in the long term.
The opportunity cost of saving instead of spending
Believe it or not, sometimes saving isn’t the best financial move that you can make, especially when it comes to business opportunities.
For example, if you owned a clothing store and made the decision to save $2,000 of your profits instead of using them to refurbish the shop, you could potentially be losing out on increased revenue and brand recognition that may have come from a new look.
Does opportunity cost always involve money?
The opportunity cost does not always have to be about money.
Time is another factor that is taken into account when figuring out the opportunity cost of a financial opportunity.
You could either spend 10 hours learning a new skill for a business idea or use the 10 hours to research an investment opportunity. The difference between the value of each one would be the opportunity cost.
Another example is when someone decides to take the train to work instead of driving. It takes them 60 minutes to get there on the train and driving would have taken 40 minutes, so the opportunity cost in this situation is 20 minutes.
The opportunity cost of not investing early
Sometimes, not investing your money can lose you even more than a bad investment choice. This is because the earlier that you start investing, the bigger the rewards long-term.
As an example, someone who puts $1,200 each month into a 5% interest savings account at age 35 will have $1m by the age of 65. If another person saves $1,200 a month from age 45, that person will have to save twice as much to reap the same return on their investment.
What is the difference between sunk cost and opportunity cost?
A sunk cost is money that has already been spent and can’t be regained. Equipment, machinery and rent for a factory are typical sunk costs.
Businesses take sunk costs into account when deciding whether to invest in a project or new stock.
The difference between a sunk cost and an opportunity cost is that an opportunity cost represents potential future returns on investment, whereas sunk cost is money that has been spent in the past. The opportunity cost focuses on where money could have been better spent.
How to choose between saving and investing
So, when is saving the right financial choice, and when is investing a smarter move?
To answer this question, you need to consider the pros and cons of each.
The pros of saving
- You will know exactly how much interest you will make on your money upfront.
- There are minimal to zero fees for putting your money into a savings account.
- On most occasions you can access your money quickly
- Opening a savings account is a simple and quick process that doesn’t require much research or consideration, apart from trying to find the best interest rate available.
The cons of saving
- The return on your investment from a savings account is normally quite low.
- Inflation can affect your money and purchasing power over time.
- You may miss out on profitable investment opportunities.
- If you have debt, your money would be better used to pay this off rather than saving it in an account.
The pros of investing
- Investing in the stock market will allow you to grow with the economy, maximizing your profits.
- Some investments have the opportunity to provide you with large, long-term returns.
- Allows people to earn a regular income.
- There are lots of investment opportunities available to suit each person’s financial situation and personal goals.
The cons of investing
- Investments don’t always come with a guaranteed return, which means your money could be at risk.
- Investing can be slow and it may take several years before you see a return on your investment.
- Some investment opportunities are complicated and come with lots of terms and conditions that need to be reviewed by a legal professional.
- It’s possible that some investment opportunities come with a compliance and regulatory risk if new rules of legislation were introduced.
The importance of opportunity cost
Understanding the concept of opportunity cost is a key part of helping us decide the best place to put our money to maximize our return cost.
Financial literacy is a major part of equipping us with the information and skills that we need to successfully manage our money. The best financial opportunity is the one that gives you future opportunities.
Want to improve your financial knowledge? Regularly check out our personal finance blog for the latest advice on how to take control of your finances.