We are bombarded with spending decisions every day. Some decisions are made for us by default such as housing and commuting costs, and hopefully also retirement and savings, but our remaining disposable income is free to spend as we please. If you have $5 and spend it on coffee, you can no longer buy avocado toast. This is the essence of opportunity cost. Here are some ways to think about opportunity cost.
With the infinite number of choices, our minds find shortcuts to help us categorize and make choices. There are even rules of thumb such as no more than 30% of gross income should be allocated to housing. These guidelines help us make budgets so that we don’t accidentally overspend on housing, and end up with less. However, it is important to understand that one dollar is one dollar, regardless if it’s spent on housing or avocado toast. Money is fungible.
Although a dollar is a dollar, some choices are more valuable than others. If you enjoy books, $5 spent on books is more useful to you than $5 on movies. Another way to frame this is that opportunity cost is the next best thing you could have chosen to spend your money on. This example assumes that $5 on books is the best choice, and you gave up on an audiobook, which is also good, but not as good as a real book. A different person may like something completely different. Opportunity cost can be deeply personal.
In the investments world, opportunity cost is a little more straightforward, measured by interest rates and investment returns. If you choose to invest in bonds which yields 2% instead of stocks that yield 10%, your opportunity cost is the difference, or 8% loss of income. You chose safety over risk.
Whatever choices you decide to make, keep in mind that even though you have disposable income and are mentally categorizing it as “fun money”, you always have the opportunity cost of saving it for retirement or some other future use. Understanding opportunity costs can help us make better spending decisions.