Understanding Opportunity Cost

I was having a conversation with a good friend yesterday. This friend and his wife are lovely people but have a complete lack of financial knowledge, and fall into the category of having to work until they die because they have never been able to save or invest and basically spend every dollar they earn.

The converstaion I had with my friend, was an excellent lesson in both opportunity cost.

So what it opportunity cost? Simply put, it is missing out on an investement opportunity because of a previous decision. For example, putting one's money in a term deposit to earn (say) 4.5%pa interest return, rather than investing in (say) a property trust that gives a 7.5%pa rental return PLUS 8%pa capital gain, is an example of opportunity cost.

The term deposit may seem "secure and safe", but the cost (or opportunity cost) of that percieved security and safety, means that the investor foregoes the extra 11% return (7.5%+8.0%-4.5%=11%) in order to "feel" that their investment is "safe".

Now that we understand opportunity cost, let's go back to the conversation with my friend....

My friend and his wife enjoy boating on the weekends. They have had a trailer boat for around 7 years. Last year, they decided to get a bigger trailer boat. However, rather than first selling their existing one, they just bought a second boat and assumed their original boat would just sell on the market.

It has not.

Not only has it not sold, but there has been no interest from any potential buyers.

Rather than reduce the price to sell the boat (probably worth $60,000), they choose to stick to their price - which is appears to be too expensive.

My friend says that the boat is costing them $100 per month on insurance and registration just to sit on the front lawn and it is a waste of money. I agree.

So what does this example have to do with opportunity cost?

Our friends will not reduce their price by $10,000 to sell it for (say) $60,000.

They see that it is costing them just $1,200 per year.

What they fail to see is that the boat is also devaluing every year by another 5% or so. That is approx a further $3,000 per year. At total loss of $4,200 per year.

However, if we take this example a little further, and look at an actual real alternative option for their situation:

• IF they had reduced the price around 1 year ago, and sold it for $60,000, they would have saved $1,200 in insurance and registration and the devaluation of $3,000.

• If they then took the $60,000 and invested it is something simple like Australian Bank Shares (the same bank they would be comfortable having a term deposit with), they would have had around 8% dividend (I'm including franking credits) of $4,800 PLUS a capital gain of 26% equating to a $15,500 capital gain.

In other words, their decision NOT to reduce the price and sell the boat 12 months ago, because they don't want to lose around $10,000 of percieved value, has, in reality, cost them $4,800 + $15,500 = $20,400.

That $20,400, is the actual Opportunity Cost of their decision, and that is just in the first year. Even if they have no further capital gains, they are still missing out on around $5,000 per year in dividends.

After 2 years they will have lost a $25,200 opportunity and after 3 years it's $30,000!

This is true opportunity cost!

The worst part is that, they honestly believe the only cost to them is just $1,200 per year!

This is why you NEED to develop the skills to be able to look deeper into financial decisions and outcomes, so you can maximise your returns and minimise your costs.