Developing a Wealthy Mindset: Understanding the Concept of Opportunity Costs
The average American household is in over $100,000 of debt. Nearly 60% of American adults don’t feel they are on track to enjoy a comfortable retirement. These are scary figures. While the average person seems to be slowly sinking in financial quicksand, the wealthy are busy adding an extra yacht to their fleet, scooping up a third vacation home in Italy, or even blasting off into space just for fun. On the surface, it feels like wealthy people are careless with their money. What we don’t see is the underlying thought process that has given them the ability to build considerable wealth in the first place.
Now, before you read further, I’m not one of those financial coaches that lies to their clients by saying that anyone could become a centi-millionaire or billionaire if you just work hard enough or invest in smart things. That’s utter bullshit. Luck has a huge part to play in these rare occurrences more than financial prowess. However, what I will say is that most wealthy people think about money in a very different way than the average Joe. They have the foresight to understand the long term impacts that each decision has on their financials. They understand that what you see on the surface isn’t the full story. Most millionaires look beyond the purchase price of a product or service. What you pay today, isn’t the true cost. This is something that most poor people fail to understand.
Wealthy people understand that every action they take with money will have long-term financial impacts. No matter how big or small the financial transaction, they’re pros at spotting the opportunity cost of each action. In this article, I’m going to teach you how to shift your mindset and think like the ultrawealthy.
What is Opportunity Cost?
Simply put, opportunity cost is something you miss out on by choosing an alternate path. This doesn’t just apply to financial concepts, it can be anything really. It’s just what you give up in order to get something else. It’s up to the individual to decide if the cost is actually worth the reward. In some cases, it’s a no brainer. Other examples are a bit more ambiguous.
From a financial perspective, the opportunity cost might be giving up the potential for higher returns to invest in safer assets. You might give up a higher salary (opportunity cost) in exchange for a job that has lower stress. Or choosing to go to college to increase your earning potential while missing out on the potential to stay in the workforce and earning money now. It’s important to note that opportunity cost doesn’t have to be financial. You might miss out on quality time with friends and family (opportunity cost) because you spend hours and hours scrolling through social media like a zombie. It could also mean giving up staying in shape (opportunity cost) in exchange for one more scoop of Rocky Road.
At the end of the day, it’s up to you to decide if the opportunity cost is worth it. The problem is that opportunity costs aren’t easy to spot. The trick is to change your mindset to consider what you might be giving up to purchase that thing you really want to buy. This is much easier said than done. I’ll prove it to you. What if I told you that the opportunity cost of your Netflix subscription is tens of thousands of dollars? You’d think I was crazy, right? Well, I hate to break it to you but the math backs up my claim.
Most people see their monthly Netflix subscription (which currently sits at $16 per month) as a minor expense in their budget. This small amount of money seems like a steal considering the hours and hours of entertainment that you get as a result. While that may be true, let’s consider what you are giving up instead. Let’s say that instead of paying Netflix each month, you invest this money in an index fund that returns 10% each year. If you’re 30 years old, this would grow to over $60,000 by the time you are ready to retire at 65!
Now, I’m not advocating for ditching Netflix or any other expense that brings joy to your life. I’m just pointing out that you need to look past how much something costs and determine if the opportunity cost justifies the expense. By shifting your mindset, you can make smarter financial decisions that are very minor but add up to significant amounts over your lifetime.
Why People Struggle With the Concept of Opportunity Costs
The reality is that most people don’t grow up think about money in terms of opportunity costs. I know I didn’t. I grew up thinking that the price you pay at the register is the all in cost. Money was nothing more than a medium to exchange for living expenses. It wasn’t until I started to understand what I was giving up to buy things I didn’t want or need that my mindset changed. Like wealthy people, I now realize that money is nothing more than a tool. And tools are good for one thing, getting to work!
Now, spotting opportunity costs and making smart financial decisions are two different things. Wealthy people look to make decisions with their finances that bring the greatest long-term benefit. They understand that if they give up the new shiny object today and let their money work for them first, they’ll be able to buy a much nicer shiny object a year from now. This sometimes requires a lot of willpower. It’s much easier to get a little enjoyment today than delay your gratification for 5 years, 10 years, or more. Discipline is required if you are going to spot and leverage opportunity costs.
Here are somethings you can do today to start switching to an opportunity cost mindset.
Get out your budget. Next to each line item, write how much money each expense would be worth if you could avoid it altogether. If it’s an expense that you must have (like car insurance), you could calculate how much it would be if you renegotiated your rate and saved $20 per month instead. This will help you get an understanding of the true cost.
At a 10% return, your money should double every 7 years. Next time you are shopping, use this formula to quickly calculate the opportunity cost. For example, if you’re looking to buy a $500 television, that money would grow to $1,000 in 7 years, $2,000 in 14 years, $4,000 in 21 years, $8,000 in 28 years, $16,000 in 35 years, etc. As you can see, the opportunity cost increases exponentially if you are younger and have longer to invest.
Sometimes its useful to think about things in terms of time costs. For example, if you make $20 per hour and you want to buy something that is $100, it will require 5 hours of your time to earn the money. Is that thing worth doing your job for five hours? If the answer is no, you probably shouldn’t buy it.
As you can see from the examples provided, it really doesn’t take big changes in your finances to quickly build financial stability. Making a few minor adjustments can easily add hundreds of thousands to your retirement savings and investments over your lifetime. The problem is that most people can’t see these opportunity costs. But if you’re like me, once you understand the concept of opportunity cost, it’s not something that can be unseen.
