Monthly Archives: June 2013

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Opportunity cost

Sometimes I think I have an unfair advantage. I have mental machinery that allows me to make better decisions than people without that machinery. But I’m not talking about intelligence or analytical ability or anything with a physiological basis. The machinery is just concepts, ideas, ways of thinking that I can bring to bear on a decision. And it’s not built in, but the product of things I’ve learned. So you can have this machinery too, if you don’t already, and in turn make better decisions.

The most basic decision-making tool that I’m regularly thankful for is the concept of opportunity cost. It’s a high school economics concept, so you’ve probably heard of it before, perhaps even have understood it well. If you regularly look for opportunity costs when making decisions–large and small, financial and non-financial–then you can stop reading now, I’m not going to say anything new. But if you don’t wield the concept regularly, apply it to every big decision and many small ones, then you’re not quite gaining the advantage that you might. Opportunity costs are present with every decision, they accompany every action that excludes others. Consciously looking for and considering the opportunity costs of your (in)action can help you make reliably better decisions than if you hadn’t.

The opportunity cost of an action is the value of the best foregone alternative. In a simple binary decision, where you must choose one of two options, the opportunity cost of taking one option is the value of the other option that you can therefore not take. Most decisions are more complex than a forced two-way choice, though, so opportunity costs can be harder to see.

The basic high-school economics example is buying something. The opportunity cost of spending your money on some good or service is the best alternative thing you could have spent your money on instead. Money works really well here, as it directly represents deferred opportunity–the opportunity to buy something later. Everyone understands that whey they spend their money, they can’t spend it again, and people regularly consider what else they could spend their money on when evaluating a purchase. For small, day to day purchases like groceries, transport and entertainment, many people have enough money that they don’t have to worry about opportunity costs: you can both buy the chocolate and go to see a movie and not have to worry about affording a taxi home. As purchases become more expensive people become more aware of the foregone opportunities they imply: you might not buy the most expensive wine, even if you believe you will enjoy it more, because you understand that that money might be better spent on something else of greater utility, even if that something else remains abstract at the time.

Investments also present opportunity costs, sometimes less easy to recognise. If you invest your savings in a stable term deposit, you forego the potentially higher returns of investing that money in an index fund or stocks or property or precious metals or art or anything else that might bring a higher return. Of course, those alternatives carry varying levels of risk so a higher potential return is not necessarily better, but you can only invest each dollar in one at a time. And just the same in reverse: in buying shares you forego the stability and guaranteed returns of holding cash.

Property is an investment people commonly make without fully considering the opportunity costs. Yes, property is an asset that’s fairly likely to appreciate over the long term, but the monetary costs are higher than just the mortgage repayments (which alone at least double the purchase price over a typical loan period): transaction costs, insurance, property taxes, repairs and maintenance all add up. The opportunity cost of home ownership is the best alternative investment you could have made with all that money, less rent to live somewhere else. Renovations carry the same opportunity cost, often overlooked. Yes, you might “earn it back” when you eventually sell, but you’ll give up the returns of investing the removation’s cost somewhere it might otherwise earn compounding returns until that time. Most people still end up ahead, of course, but property is not the obvious investment slam dunk it’s often conceived to be. Especially not if you can’t guarantee a value doubling every 10-15 years.

A car is a terrible investment. Not only will its value plummet and maintenance costs increase, but the true opportunity cost includes the return you could have earned investing that twenty thousand dollars plus upkeep somewhere else for the duration of ownership. The transportation benefits are real, but these can be obtained in other ways, too, including public transport, taxis, and car-share schemes, all of which leave your money free to invest elsewhere.

Opportunity costs arise in every decision, not just purchases and investments. In non-purchasing decisions, the opportunity costs can be even harder to see. This is where having the mental label “opportunity cost” and knowing to look for it starts to feel like an unfair advantage.

Many decisions have exclusive options: you can only choose one. People can generally only take one full-time job at a time, have one romantic partner, live in one city. It’s tempting to take the first good option that presents itself, but the opportunity cost of doing so includes the value of the best alternative, including those you haven’t discovered yet. Your time and energy are limited and valuable resources, and in devoting them to the first option that doesn’t suck you’re likely paying a huge opportunity cost. This is painfully obvious in employment where, anecdotally at least, so many people seem to end up dissatisfied with their career, which is often the first career they pursued, and after which commencing they stopped exploring other options.

It’s a big and under-acknowledged problem for entrepreneurs as well. Most people can only start one company at at time (it’s hard!) and so in starting a company based on the first idea you get excited about, you incur the opportunity cost of not pursuing the best idea you might have had if you had kept exploring. Your first idea is unlikely your best. The cost of building a product is not just the development expenses, it’s the impact and value of the best product you didn’t build instead.

Full-time work has a big opportunity cost for me. I tend to pour all my energy in to whatever project and team I’m working with, and the cost is that I have nothing left to give to my own ideas. Employment costs me time for high-level strategic thinking about my life, not just during the office hours each day, but in the hours at home recovering and recharging too. I don’t think it’s just me: many engineers complain about not wanting to code when they get home from work. Working on a major project is exclusive of any other projects, major or not. The opportunity cost of employment is not just the hours you’re paid for, it’s the value (monetary and intangible) of the best alternative project you could put any effort into at all.

So, opportunity costs arise in nearly every decision, but they can be hard to see. The opportunity cost can be hidden, or unknown, or implicit. Avoiding decisions carries costs too: the cost of enjoying the benefit of whichever option you choose (although postponing is often advantageous if you’ll gather more information). If you’re unsatisfied in your job, then doing nothing about it isn’t free, even though you can’t see the cost. The opportunity cost of turning up every day includes the foregone enjoyment of the best alternative job you might reasonably get (including those you don’t know about yet).

Having the concept of opportunity cost in my mental arsenal helps me seek out these costs when they’re not obvious, which in turn helps me make more informed decisions. Understanding foregone alternatives as costs can also help reframe dilemmas that evoke emotional responses too. For example, in deciding whether I can discard some piece of old clothing I never wear, I find it helps to frame the decision as: would I buy it for a dollar if it was in a store today? This suppresses the hoarding instinct and helps me realise that no, it’s not worth the space it would fill. Similarly, if you’re unhappy in your job or working on a project you don’t believe in, try reframing the dilemma: would you take this job/project if it were offered to you anew today? This framing can help balance your current situation against the now-more-obvious alternatives you are foregoing.

More mental machinery coming soon!