As the rapper Azelia Banks says in her song Fantasea, "Life is a series of choices" — an idea to keep in mind when it comes to your money.
In finance, choices are often weighed in terms of "opportunity costs," or what you're passing up when you choose one investment over an alternative. As Investopedia describes it, "Say you invest in a stock and it returns a paltry 2 percent over the year. In placing your money in the stock, you gave up the opportunity of another investment — say, a risk-free government bond yielding 6 percent. In this situation, your opportunity costs are 4 percent (6 percent - 2 percent)."
Thinking about opportunity costs helps investors weigh options ahead of time, and determine how successful each choice was in hindsight. It's also an essential concept to understanding your personal finances.
Think of it in terms of skirts.
Say you decide it's time to own a leather skirt. After doing a little research, you narrow your options down to two skirts: A genuine leather one from Max Mara that's $450, and similar faux leather one from Zara that's just $50.
The dollar opportunity cost of going with the Max Mara Skirt is clearly $400, which you'll have to weigh against certain intangibles. Maybe the fit of the Zara skirt is slightly less flattering, or the construction is less durable, or it bothers you slightly that someone with a trained eye would identify the cheap faux leather.
But when it comes to personal finance, experts encourage you to look at another option, too: What happens if instead of buying either skirt, you put the money in an investment, like a bond or money market account. "There's a double whammy attached to every dollar you spend," says Susan L. Hirshman in her personal finance book Does This Make My Assets Look Fat. "A dollar you spend is a dollar you can't invest. And since an invested dollar often earns more money, the dollar you spend is really more than a dollar."
So, instead of buying the Max Mara skirt, you put that money in an investment that makes 12 percent interest (slightly less than the S&P 500 yielded last year). At the end of the year, you would have $504 — which means the opportunity cost is actually a gain of $54.
Coincidentally, that's enough to buy the Zara skirt. By measuring opportunity costs beforehand, you can have one of the options essentially for free.
It's not to say that you should never buy skirts, just that you should consider what you stand to lose — or gain — from making a different decision.
"Opportunity cost is just a way to measure the impact of making trade-offs when you can't have it all," says Hirshman. "And with a few exceptions like Bill Gates, we can't have it all."
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