One of the most famous quotes in history is, "There's no such thing as a free lunch." This adage refers to the idea that it is impossible for a person to get something for nothing. Every choice you make has a next-best alternative that you could have chosen but didn't. That foregone opportunity is known as opportunity cost. That is, the price you paid for doing whatever you did was an opportunity you can no longer enjoy.
- Opportunity costs occur whenever a choice is made between two or more options.
- The best way to protect yourself from opportunity costs is to fully understand all your options and take advantage of as many of them as you can.
- Doing nothing is a choice, so the opportunity costs of inaction can't be overlooked.
Managing Opportunity Cost
Whether or not you are successful in life depends almost entirely on how well you manage your own opportunity cost. What if Julia Child hadn't begun cooking at age 37? What if Sam Walton hadn't started Walmart stores at 44 years old? In retrospect, the opportunity cost of each of those decisions would have been staggering.
Opportunity cost is all around you. As the CEO of your time here on Earth, you must decide how to manage your opportunity costs. You must make decisions such as:
- Do you go to art school or become a doctor?
- Do you invest in the high-tech startup your friends are putting together or strike out on your own?
- Do you go to the gym or eat a cookie?
- Should you apply for that job in the industry you love or stick with a more comfortable field?
Protect Against Opportunity Cost Mistakes
The saying that there's no such thing as a free lunch is especially present in your finances. If you don't understand the power of compound interest, the opportunity cost can go unnoticed. But the outcomes of small decisions can have a huge impact on where you end up on your journey to wealth. Instead of buying a single $6 coffee from Starbucks, invest the money at a 10% return for 50 years, and you'll have $470. In that same regard, spending $9 on lunch is really $1,057 in future wealth gone.
Knowledge is power. The more you know about a given area, such as investing in stocks, investing in bonds, or investing in real estate, the more options you have. Employing more options gives you a better chance to earn a decent return on your money. That means a more comfortable lifestyle for your family, less financial stress, and the freedom to pursue the things you want without always looking at the price tag.
The Cost of Doing Nothing
The biggest warning to new investors, especially young ones, is that doing nothing is a choice. That means it has opportunity costs. By not investing when you have the chance, the foregone wealth is staggering.
Let's look at a few examples and scenarios.
- John is 18 years old. He gets an after-school job and opens a Roth IRA, where he saves $5,000 per year until he turns 70 years old. He invests in low-cost index funds and practices dollar-cost averaging while reinvesting his dividends. John earns the same return the market has for the past century or two, which is roughly 10%, and he ends up with a little more than $7,000,000 in wealth.
- Adam is also 18 years old. He gets an after-school job but doesn't save anything. He waits until he is 30 years old to open a series of retirement accounts and saves $5,000 per year. He's only $60,000 in total contributions behind John, and still has 40 years to go before he turns 70, so he figures it isn't too bad. But when he retires, he has only $2,200,000. That $60,000 shortfall turned into a $4,800,000 canyon.
In fact, by starting at 30, Adam would have to save a whopping $16,000 per year simply to break even with John, who has continued to save just $5,000 per year. The opportunity cost of blowing his income as a young adult had enormous consequences later in life. That is okay if Adam thought through those choices and decided that is what he wanted. Most people don't, though, and that is the problem. That is why they say there's no such thing as a free lunch. To live your best life possible, you must understand opportunity cost and the power of compound interest.