Opportunity costs of money

Think differently about money to spend less and invest more.

For the average Joe reading this heading, it might not make any sense at first, but understanding the opportunity costs of money will give you the insight needed that will help you to think before you buy or spend and in turn help you control your finances. Understanding the opportunity cost of money will help you on your path to financial independence.

Choices you have with money

Every day we face choices with money, and the two main options are either spend it on things or save and invest your money. Most people spend frivolously as we are influenced by the media in the consumption-driven age we live in, making it harder to save and invest for the average person. Understanding that there is a cost involved when spending frivolously will make you a better investor. 

What is the opportunity cost of money?

It's the value of what you could have earned on money when you spent it on something else. Just as investment compounds, the opportunity cost of money compounds too. When you don't spend money on unnecessary things it will hopefully be saved or invested in a place where you earn income on that money, meaning you can only have opportunity cost if you save and invest. Opportunity cost grows as your expense grows and reduces the more you save and invest, and we at Finsesh want to keep our opportunity costs to a minimum, meaning you don't spend unnecessarily and we maximise our investments. 

Examples of opportunity costs: Let's say an investment made 20% returns last year, but you spent R50 000 on holiday the December prior. That means you had an opportunity cost of R50 000 times 20%, which equals R10 000. Next year your cost of R10 000 grows by another 20% meaning in year two your cost of that holiday goes up to R12 000. These forgone earnings are opportunity costs.

Let's use another popular example: Buying expensive cars. Person X buys an R450 000 car and agrees to repay the car in 5 years at a prime rate (9.75%) Your monthly installments are R9600.42, and your interest over this period is R120 677.53. You spent R570 677.53 on a car that will lose 40% of its value in the first 5 years and will be worth R270 000 once it's repaid. 

If R9600.42 per month was invested at a growth rate of 10% per year your investment would be worth R743 428.42 over the 5 years. This means your opportunity cost is what you could have in savings (R743 428.42) and what you have in car value (R270 000) which is a whopping R473 428.42 loss of opportunity cost.

How to think of opportunity costs

Adding a real number as opportunity costs to every Rand or R1000 you spend will make you think twice before you spend on unnecessary things. Your money is workers that you employ to make money for you while you sleep or go by your day-to-day business. Money is the hardest worker out there, never taking leave, working 24/7, and never going on strike, which makes money as a worker very reliable. Knowing that your money can work for you, so one day you can work less for your money, is how you should think about the opportunity cost. We want you to employ as many money workers as possible. 

How to calculate your opportunity cost of money

Think in terms of the stock market: Choose a long-term ETF or fund that you currently invest in or would invest money into. Let's use the Satrix MSCI World Equity Index Feeder Fund as an example. This fund has a since inception return of 13%. If you spent R10 000 unnecessarily then your opportunity cost is 13% of R10 000, which is R1300 missed out on every year. As mentioned this R1300 amount compounds too, meaning every year this opportunity cost grows. If you spent your money investing in this fund, you would start employing extra money workers and the R1300 will be your first worker. In 10 years your spend of R10000 could have been worth R33 945, or a loss of R33 945 spent on unnecessary things. See how you have the power of choice.

Think in terms of home loans: Another way is thinking in terms of your home bond savings. Let's use a scenario where you have a bond of R1m, at current interest rates of 9.75% your monthly repayments will be R9 485 per month for 20 years. There are two ways to explain your opportunity cost: 

1: Let's continue with the example that you spend R10 000 per year on random things you don't need. The savings you will have over 20 years if R10 000 was invested once off into your home loan account will save you R57 884 in interest payments over the term of the bond.

2: Monthly repayments can be reduced by capitalising the R10 000. If you had invested the R10 000 into your property and capitalised it, your monthly repayments would reduce to R9390 per month. This means your R10000 spend is worth R95 per month for the remaining term. 

In summary

Next time before you spend money on items you don't need, ask yourself, what's the opportunity cost of these items? The more we spend on unnecessary items the bigger our opportunity cost grows. Your end goal should be to employ as many money workers as possible to convert your active income to passive income, this is the process toward your financial independence. 

If you want to find out more about becoming financially independent, please see our free course. If you want a blueprint toward financial independence, you can enroll in our Stages to financial independence course.

Onward to Financial Independence 

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