Applying The Concept Of Opportunity Costs In Personal Finance
An opportunity cost is a benefit that one person or entity would have received but lost for making one decision in place of another, both choices being mutually exclusive in that only one can be chosen and not the other. While usually expressed in monetary terms, its meaning also extends to all other real costs of choosing one over the other, such as loss of time, energy and derived use or pleasure.
In personal finance, opportunity costs are used to measure the differences in returns between an investment decision and the one that was given up, or the differences in benefits between a spending decision and its alternative. For example, a person invests in a Unit Investment Trust Fund (UITF) and decides to terminate it after three years, netting only a measly 2 percent per annum. He then realizes he would have earned 5 percent if he had instead invested the money in corporate bonds. His opportunity cost is, therefore, the difference between what he would have earned and his actual earnings, so 3 percent.
More important than being a measure, opportunity costs are used as a reference when making investment or spending decisions. Assuming risks are equal in all options and mutually exclusive of each other, it would be prudent for investors or any Juan de la Cruz to weigh in on opportunity costs when deciding on where to place their money. Here are some examples:
Saving or spending. Let us say a person is contemplating on buying a new sport-utility vehicle (SUV) in cash to replace a five-year-old car that is fully depreciated but is still in the best condition versus placing the money into a variable universal life insurance (VUL) investment with a term of five years. If he decides to buy the SUV, his opportunity cost is the depreciation of the SUV plus the difference in maintenance and insurance costs of the two types of cars plus his potential earnings from the VUL over the next five years. On the other hand, the opportunity cost of placing the money in a VUL investment is the greater comfort and safety that the new SUV would have given this person and his family during the same period.
Renting vs buying a home. There have been many debates about which one is better. The one consideration would be to determine which one has the lower opportunity cost. The opportunity cost of renting a home is the potential appreciation of an owned property, which could later be sold at a profit, at the minimum offsetting all expenses made for owning the property. On the other hand, the opportunity cost of buying a home is the potential earnings of the full payment or down payment plus the difference in the monthly amortizations and the rental expense when placed in, say, an equity fund, and the comforting thought of residing in a house that you already own.
Time deposit vs regular savings. Emergency funds are supposed to be easily accessible in that it is often advised that they be parked in a regular savings account which earns 0.3 percent per annum. On the other hand, a time-deposit (TD) account earns 1.3 percent if placed for one year. Assuming no emergencies occur within the year, a person who decides to place his funds in a TD account, instead of in a regular savings account, would earn 1 percent more. This, in effect, would be the opportunity cost of keeping the funds in a regular savings account.
Running a business vs regular employment. The opportunity cost of running a business is the fixed income that a person would have earned had he decided to stay employed. However, if his business succeeds and grows, he will be earning much more than his employment compensation and benefits, and so shall offset his earnings losses for not being employed. These potential higher earnings would, therefore, be the opportunity cost of staying employed.
Keeping a losing stock vs buying a potential gainer. If a person had bought shares of stock A, which belongs to a declining industry and which had already lost 50 percent of its original value, he would be better off selling these shares of stock and then purchasing those of stock B, which belongs to a thriving industry and expect to recover his losses over a much shorter period. The opportunity cost of holding on to a losing stock is the earnings from selling it and then buying stocks of a potential gainer.
Understanding the concept of opportunity costs and how you can apply it in your personal and investment decisions is an important tool that will allow you to maximize the use of your money. Make it a regular consideration when making money decisions so that you get the best benefit from among the options.
Eve Reyes Mercado is a registered financial planner of RFP Philippines. To learn more about personal financial planning, attend the 57th RFP program from October 1 to November 19. To inquire, e-mail firstname.lastname@example.org or text <name><e-mail> <RFP> at 0917-9689774.
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