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Opportunity Cost

WE ALL HAVE limited money, so we need to weigh carefully how best to use our dollars. That means pondering not only what we’re getting, but also what we’re giving up. This is one of life’s great financial tradeoffs, rivaling the tradeoff between risk and reward.

Indeed, at times, the two notions overlap. Suppose we stash our money in bonds and notch 3% a year. Yes, our wealth will grow. But if we had bought stocks instead, we might have earned 7% a year, so our more conservative approach—even though it made us money—came with an opportunity cost.

Should we feel badly about the opportunity costs we incur? It depends. We shouldn’t regret failing to invest in the stock market if, say, our time horizon is short and owning stocks simply wouldn’t have been prudent. We also shouldn’t look at the fabulous performance of a single highflying stock or one hot market sector and feel we missed out, because there’s no way to know which parts of the stock market will soar and it isn’t prudent to make such narrowly focused bets.

The notion of opportunity cost can also be applied to spending. Suppose we’re eyeing a shiny bauble. If we buy it, we give up the chance to purchase something else, either now or at some future date. Indeed, if we forgo today’s spending and save the money, we might have far more money to spend in the future, depending on the rate of return earned during the intervening years.

The biggest problem with opportunity cost: Often, we don’t even consider it. An investment or a purchase catches our attention and we’re so captivated that we snap it up, giving into our instincts without considering the alternatives. To avoid this mistake, we need to slow ourselves down, giving the contemplative side of our brain a chance to weigh in—and to suggest that perhaps there are better uses for our money.

Next: Compounding

Previous: Risk and Reward

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