DISCLAIMER: I am not a financial advisor and this should not be taken to be financial advice. You should consult a financial professional for advice. I am a financial amateur. These are my thoughts and opinions on money that I have recorded here for my children, with the hope that my thoughts might help them. They are responsible for the results of the advice they choose to follow. Always worth keeping in mind: Past performance is no guarantee of future results. Your mileage may vary. The map is not the territory. Keep your eyes open. Smell it before you take a bite.
To my children:
Nothing is free. Things cost money or time or opportunities. Opportunity cost is the idea that each thing you do, with your money or your time or any other resource, has a cost. The cost of choosing what you choose is missing out on whatever you chose to miss out on. Pretend you’re in a maze where one path goes left and one path goes right. If you choose one, you can’t go on the other. The cost of what you choose is what you don’t choose. When you choose the best option, you miss out on the next best option. That’s fine, as long as you’re right. But to make sure that you’re right, or at least very comfortable with your decision, you owe it to yourself to look at the other options to see if one of them might in fact be better than the one that you’re choosing.
In terms of money, it’s usually pretty straightforward because you just pick the option that makes you more money. If you are offered a job packing boxes that pays $10/hour and another job packing boxes that pays $15/hour, and all else is equal, then the choice is clear—you should take the job that pays $15/hour. But of course there are other things besides money that affect decisions that involve money. If the other parts of the situation aren’t equal, and the $15/hour job is farther away from your house and the boss seems worse, then maybe you’ll choose the $10/hour job instead. That’s perfectly fine.
To reuse a previous example, paying for a car in cash might sound like a good idea compared to taking out a loan to buy the car because you’ll have to pay interest on the loan and that will add up to more than the price for paying in cash BUT when you take out a loan to pay for the car, you get to hold onto your cash and you could invest in a relatively conservative way in a stock market index fund that would cover the interest you’re paying on the loan, with some profit left over for you to keep. So the cost of paying in cash is missing out the investment gains you could have made if you held onto your cash and invested it and paid for your car with a loan. And you can look at it the other way too, because there is always a cost to your choice. The cost of taking out a loan to pay for your car is the interest you have to pay on the loan and the risk that your stock market investment return rate will not be above the interest rate of the loan and the loan will end up costing you more overall than if you had paid in cash.
With money matters, it’s helpful to ask yourself, “What else could I be doing with my money?”
Bottom Line: There is a cost to everything, to every choice, called opportunity cost. The cost of your choice is missing out on what you don’t choose. Explore the options thoroughly to be comfortable with the choices you make.