Opportunity cost is a fundamental concept in economics. It’s the value of the best alternative forgone. When you choose to do X, you forego the value of doing Y.
Opportunity cost is everywhere in our financial decisions. The opportunity cost for choosing to live in a low-cost-of-living area is the higher pay and more abundant jobs in a high-cost-of-living area. The opportunity cost for contributing to a Roth 401k is the tax deduction you would get from contributing to a traditional 401k.
Life is full of choices. Wherever there are choices, you will have opportunity cost.
Is an opportunity cost just as real as an actual cost out of pocket? Should we discount the opportunity cost by chalking it up to “could’ve had a V8”?
The opportunity cost has to be realistically expected beforehand. It can’t be just a lucky outcome after the fact. The opportunity cost for investing in index funds isn’t buying an IPO that happened to take off.
However, the opportunity cost is every bit as real. If you own your home free-and-clear, your housing cost isn’t just your property tax and maintenance. If you rented, you would free up the money and earn income on it. That’s why “owner’s equivalent rent” is part of the CPI. If you stay at home to take care of your kids, your childcare cost isn’t zero. You are just paying it with the foregone salary from working elsewhere. When you assess your cost of living, you have to include your opportunity cost. Otherwise it isn’t the true picture.
A co-worker takes pride in being frugal and saving money. He brown-bags for lunch every day. He stays at Motel 6 when he travels. When we talked about early retirement the other day, because he’s interested in some leisure activities, I said the largest cost of early retirement isn’t housing or health care. It’s the opportunity cost — the income he’ll give up if he retires early.
At his after-tax income, it’s like buying a few new BMWs each year and sending them to the junk yard without even bothering to trade them in, just so he can spend his time the way he likes. When he asked me what was the point in penny-pinching and turning around throwing away money like that, I didn’t have a good answer, except by saying that early retirement is a luxury lifestyle.
When your time is valued highly by others for doing things you do well, you will have to pay the same high price (after taxes) if you want to spend your time on something else. There’s nothing wrong in pursuing a luxury lifestyle. Luxuries are usually more enjoyable. It’s just the polar opposite of being frugal.
I’m not saying retiring early isn’t worth a few BMWs each year. The cost and its luxury nature just have to be recognized. People with a higher income tend to have this choice. The higher opportunity cost makes the choice more difficult. People who are more frugal tend to have this choice. The contrast between the frugal habits and the high opportunity cost also makes the choice more difficult. Ironic, isn’t it?