And what’s its role in creating wealth?
In this newsletter, I want to look at costs. Not just any costs, mind you, but a special kind known as ‘opportunity costs’ and its importance in wealth creation.
The concept of opportunity costs is well covered in most university courses in finance and accounting, but often gets overlooked in personal finances.
So, what is opportunity cost?
To start with, it is not a cost that is directly incurred, like the cost of a bunch of groceries or a new car. It is the extra cost incurred in making a purchase, over and above a lower cost that might have been incurred for a similar purchase. (Yes, yuk.) It will be clearer if we look at an example.
If we buy a car for $45,000 when another car costing $35,000 would have done the job, then the opportunity cost is $10,000. To put it another way, by buying the car for $45,000, you have given up the opportunity to use the $10,000 for something else, such as long-term investment or paying down the mortgage.
Let’s look further at the car example. According to the RAC, the cost of running a medium size car (such as a Camry, with a list price of $34,990) is $859 per month. This figure is arrived at after taking account of on-road costs, running costs, depreciation and final sale price.
On the other hand, a Land Cruiser Prado, with a list price of $63,990, costs $1441.44 per month. Thus the opportunity cost of buying the more expensive car is the difference between the two, or $1441.44pm minus $859pm. This comes to $582.44 pm.
What do we do with this money?
The next question is what do we do with this money? This is where it starts to get interesting – where compound interest meets opportunity cost.
If the amount of $582.44 per month is invested into long-term investments, how much might it turn into?
In order to work this out, we need to decide what earning rate to use. The long-term return from the Australian sharemarket is 10% per annum. In order to get a meaningful answer, we should also allow for inflation. If we allow 3% pa for inflation, then the real long-term return on Australian shares comes down to 7% pa.
If we stay true to the cause and keep buying the lower cost car each time we renew vehicles, we will be able to keep investing $582.44 pm (inflation adjusted) over the longer term. Assuming we leave the earnings in there to compound, then according to the compound interest calculator on the ASIC website, the investment would grow as follows:
|
NO. OF YEARS |
AMOUNT INVESTED |
TOTAL EARNINGS |
TOTAL AMOUNT |
|
5 |
$34,920 |
$6,990 |
$42,492 |
|
10 |
$69,840 |
$31,483 |
$101,905 |
|
15 |
$104,760 |
$80,788 |
$186,130 |
|
20 |
$139,680 |
$165,268 |
$305,530 |
|
25 |
$174,600 |
$299,612 |
$474,794 |
Impressive? I certainly think so. No wonder Alfred Einstein described compound interest as the eighth wonder of the world. Just look at the components of the final amount. As the term rises, so does the amount of interest, relative to the amount you have put in. In the longer term, the amount of reinvested interest considerably exceeds the amount of your own money.
Retirees
For retirees, who are drawing on their capital rather than accumulating more, the workings are more obvious, but just as important. The less you spend on any one item, the more you have invested. Both the amount invested AND what it earns will be available to you in the future.
Tax
So far we have not mentioned tax. This is deliberate. If we started delving into the tax complexities, we would soon find that there are some circumstances where tax deductions can be claimed and the whole thing soon gets very complex. If we looked at all possibilities, we could be here for the rest of the year. Suffice to say that tax considerations may narrow the gap between expensive and cheaper options but will not close it. There will still be an opportunity cost in going for the more expensive option. Do the sums!
Summary
All of this is not saying that you should always go for the cheapest option. Some people get extra pleasure from spending more on something – whether it be a more expensive car, business class travel instead of economy, a more expensive house, and so on.
However, there is always an opportunity cost in making such choices and you are trading off more consumption now, against having more to spend later.
The important thing is to take the extra costs into account, not just the here and now costs, but the longer-term opportunity costs. Make informed decisions.