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Economics is the study of how people make decisions with limited resources to satisfy unlimited wants. For some, economics is a very boring topic and something with which they never want to be involved. Whether you realize it or not, you practice economics every day when making choices. Every decision comes with a tradeoff because choosing one option means giving up another. Economists call this opportunity cost — which is simply the value of the next best alternative you did not choose.
For example, if you attend university instead of accepting a job that pays $50,000 a year, your opportunity cost is the income you would have earned while working. Over four years, that amounts to $200,000 in lost wages. This does not mean university is the wrong choice; it simply means your education must provide benefits that you believe are worth at least that much or more. Opportunity cost applies to every decision from choosing between two phones to deciding how to spend or invest your money.
The decisions you make with your money are some of the most important choices you will ever face. Before making financial decisions, you should consider all of the resources available to you, including your skills, your income, and, most importantly, your time. Time is one of the greatest advantages an investor can have because it allows investments to grow through compound returns. This is why investment professionals consider a person’s age risk tolerance and financial goals before building a portfolio. A young investor can usually take more risk because they have decades for their investments to recover from market declines and continue growing. Starting to invest early is one of the most valuable financial decisions a person can make.
Many people believe that keeping their money in a savings account is the safest option. Saving money is important, but inflation slowly reduces the purchasing power of cash over time. Imagine saving $250 every month from age 20 to 60 in an account earning one percent per year. After 40 years the account would contain about $146,000 of which $120,000 would have been contributed by you. Although that balance appears impressive, inflation averaging two percent per year would reduce its real purchasing power to roughly $90,000 in today’s dollars. The number in the account continues to rise, but what that money can actually buy gradually falls.
Now compare that same monthly contribution invested in a broadly diversified ETF (exchange-traded fund) or another investment earning an average annual return of five percent. Over 40 years, you would contribute $120,000 of your own money. Through the power of compound growth, the account could grow to approximately $382,000. After adjusting for inflation, the account would still have about $235,000 in today’s purchasing power. The difference between the savings account and the investment account is not simply higher returns — it is the power of time and compound growth working in your favor over several decades.
The opportunity cost of choosing the savings account instead of investing was roughly $145,000 in real purchasing power. While no investment is guaranteed, history has consistently shown that time in the market has rewarded patient investors. Opportunity cost is much more than an economic definition because it is a way of thinking about every financial decision you make. Before spending, saving or investing, ask yourself what you are giving up by making that choice. Looking beyond the immediate decision and considering its long-term impact can help you build greater wealth over time.
This article was contributed by Seth Roberts, Intern.
