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Hello again and welcome back to the Millennial Revolution Investment Workshop! New readers, please click here to start from the beginning.
By now, we’ve done over a dozen Reader Cases on this weird little blog of ours, and contrary to popular belief, we don’t do them to make ourselves look smart (that’s just a happy side benefit). We do them to demonstrate how to a proper financial analysis of a person’s situation. The REAL hope is that by doing them over and over again for different people’s situation, our intrepid readers (you) will learn how to do it themselves and apply it to their own lives. When it comes time to make a major financial decision, we want you to be able to MATH SHIT UP and use MATH to figure out the best thing to do, rather than just rely on your idiot mother-in-law’s yelling that “Rent is throwing money away!” and “Housing always goes UP!” over Thanksgiving dinner.
So I thought I’d clear things up about something that continuously causes confusion when we do these financial analyses, and it’s something that lots of other financial blogs do as well. It’s a little something called Opportunity Cost.
Here’s how it usually goes. Someone makes a point about something stupid about, say, buying a house. To justify the money saved from not renting, they’ll tack on the Opportunity Cost of not having to pay rent in their favour. But then someone else will jump in and say “Yeah, but you’re not taking into account the Opportunity Cost of not investing your down payment!” And then someone ELSE will jump in and say “But what about having to drive from the suburbs? What about that Opportunity Cost?” And then “But what about the Opportunity Cost of sending his kids to private school?” Then everyone gets confused and nobody knows what’s going on anymore.
Here’s Investopedia’s definition.
Opportunity cost refers to a benefit that a person could have received, but gave up, to take another course of action. Stated differently, an opportunity cost represents an alternative given up when a decision is made.
Gee, thanks guys. That certainly clears things up.
For the record, I HATE Opportunity Cost. Not because it unfairly helps or penalizes one side or another, but because it universally just gets everyone confused to all Hell. Here’s why.
Know Your Scenarios
In any financial analysis, you’re trying to answer a question in the form of “Should I do something or not do something?” Common forms of this questions are:
- Should I buy this house or keep renting?
- Should I pay off my student loan or invest?
- Should I buy my wife the new purse she wants or just kill her and get a new wife?
That last one we forwarded to the FBI, but you get the picture. Each analysis is trying to answer the questions “should I do A, or should I do B?” We call these Scenario A and Scenario B, and mathing the shit up allows us to figure out what the reader should do by calculating how much money the reader has in each scenario and then just picking the higher one.
There are actually 2 ways of doing an analysis like this: A 2-scenario analysis and a 1-scenario analysis. I’ll explain the style the 2-scenario analysis first, since it’s the style we prefer and use in our case studies.
A Two-Scenario Analysis is simply running the numbers for both scenarios and then comparing them at the end. It’s more work since you have to do twice the math, but in the end it produces numbers that everyone can typically understand. Even if they disagree, they can at least understand where the numbers came from.
Let me give you an made up example to illustrate. Say we want to help a reader decide whether they want to buy a house. They’re currently renting for $1000, and they want to plunk down $500k to buy a house. Is the reader financially ahead if they buy the house?
So we do a financial projection of Scenario A: They stay put and keep renting, investing the money at a conservative ROI of 6%. Each year their investment compounds at this rate, and overall their portfolio goes up. For simplicity and the sake of example, we will assume that they save no additional money every year. It’s just the $500k portfolio and that’s it.
At this point, I’ll usually make a table and show what this does to their portfolio over a number of years. In this case, I’ll run it for 10 years and show this chart.
So, at the end of 10 years, this reader will have close to $900k in their portfolio even if they add nothing else to it.
Now let’s do Scenario B. The reader buys the house, causing their portfolio to go t0 $0. BUT they DO save rent, so they can start rebuilding their portfolio from scratch at a rate of $1000 x 12 = $12k a year. The portfolio will compound at the same rate of 6%, so we’ll project the reader’s portfolio over the same 10 year period and get this chart.
At the end of 10 years, our reader in Scenario B will have a house, but his retirement portfolio will only be $158k instead of $900k. So based on this analysis we would conclude that you can buy the house if you want, but you ain’t retiring anytime soon if you do. And then everyone fights in the comments, and that’s we call a Friday here at Millennial Revolution.
You may have noticed that Opportunity Cost never actually came up in the example above. That’s because Opportunity Costs don’t apply in a 2-scenario analysis. You just crunch the numbers in both scenarios, project it out, and then calculate the end scenario. Badda-bing-badda-boom.
Opportunity Costs only show up in a 1-scenario analysis, meaning the person running the analysis is only doing the math for one scenario, and then using Opportunity Costs to account for the differences between both scenarios.
Confused yet? It gets worse.
In the above example, a typical 1-scenario analysis would assume the reader’s going to buy the house, and then start adding Opportunity Costs like so.
House Purchase Price: $500k
Rent Saved: $1000 per month
Opportunity Cost: $500k x 6% = $30k
OK right away it’s already confusing. We have a one-time cost of $500k, a monthly savings from NOT renting, and an additional annual cost of NOT investing. Already I hate this analysis.
So in order to do something similar to what we did before, we have to normalize both opportunity costs/savings so they’re both annual, and then calculate a total opportunity cost, like so:
Total Opportunity Cost = $1000 x 12 – $30000 = -$18000.
Which tells us…something. What the Hell does that number represent?
Well, here’s the thing: It TECHNICALLY represents the DIFFERENCE between performing Scenario B vs Scenario A. In other words, this $18k is the amount the reader is falling behind each month if they buy the house vs rent.
But even THAT’S not that clear, because if an Opportunity Cost is the cost of NOT doing something, then what about all the other things I’m NOT doing? And then this is typically where what I like to call the “Opportunity Cost Pile-On” happens, typified by commenters going “But you didn’t consider THIS Opportunity Cost and THAT Opportunity Cost!” And then everyone gets confused.
Because Opportunity Cost is already kind of detached from reality (It’s the cost of NOT doing something), it’s actually not that obvious what Opportunity Costs are valid and which aren’t in a 1-scenario analysis. This problem never comes up in a 2-scenario analysis because it only models things that the reader is actually doing, not stuff they MIGHT do, but AREN’T.
A typical example of this that always devolves into a commenter-fight is the statement “But you’re not taking into account the opportunity cost of renting an equivalent house!” And right away a mistake has been made because it assumes it’s possible for the reader to rent the exact same house they were attempting to buy. Not only is this usually not possible, but the reader was never even considering this in the first place. Their choice was to buy a house or stay where they are, not buy a house or rent the exact same house. But it’s not obvious that this is incorrect, is it? Because why am I allowed to penalize the reader for something they’re NOT doing (i.e. invest), but YOU aren’t allowed to penalize the reader for something they’re ALSO NOT doing (i.e. rent the same house).
In a 2-scenario analysis, this problem never comes up, because the answer to “But what if he rents the same house?” is answered simply by “Well, he’s clearly NOT renting that house.”
And That’s Why I Hate Opportunity Cost
Opportunity Cost sucks, not because it biases towards one direction or another, but because it confuses the Hell out of everyone. If it shows up in any financial analysis, it means a 1-scenario analysis is being done, which is inherently confusing. And at the end, it produces a weird franken-number which has no direction connection to reality.
That’s why we don’t use Opportunity Cost on this blog, and neither should you if you ever math shit up in your own personal finances. Stick to a 2-scenario analysis, run the math in each scenario, and in the end pick whatever number that’s higher.
It’ll never lead you wrong.
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Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.