The Power of Opportunity Cost in Making Better Financial Decisions

One of the best ways to understand money is by realizing it is all about opportunity cost. Back in 2014, I attended a seminar with Behavioral Scientist Dan Ariely. I learned many things about our decision-making behaviors, biases, and attitudes. The most memorable concept I took from that experience was related to money. "Money..." Dan explained, "is all about opportunity cost."

Opportunity cost is choosing one thing and sacrificing another one. Time is an excellent example of opportunity cost. Time is finite, and it expires. We cannot go back in time and try something again. There is an opportunity cost when we watch Netflix instead of looking for customers for our products.

There are many ways to use one dollar. Whichever one we choose, we are giving up another. We want to buy a Play Station. If we do, we won't go broke. For most of us, spending nearly 1,000 bucks on a console, controllers, games, and other peripherals will mean that we are giving something else up: a few dinners or nights out, a trip, or other high-ticket purchases we might have had in mind.

Framing money around opportunity cost allows us to make better decisions when tempted to make impulse purchases or when targeted by a "sale" or an unprecedented "offer."

A new shiny toaster, usually $300, is on sale for $100. It has over a thousand 5-star reviews, and your friends have raved about how it's a great toaster. Do you buy it? Chances are you already have a toaster. It might not be this one, but it gets the job done. So the question is not whether this is a unique opportunity to buy an appliance, but rather, what is the opportunity cost of spending that $100? Is this the best way to allocate those resources, or should you go to that fancy restaurant you have been meaning to go to with your wife?

Understanding the opportunity cost of money has become even more difficult with the digitization of money. There is a higher feeling of pain when giving a 100-dollar bill versus paying with a credit card. That is why it is even more important to consider opportunity cost.

So next time you are at Costco, tempted to buy that new speaker; or when you get that Black Friday coupon from Lululemon, think about the opportunity cost of using your money on that purchase compared to other uses. More importantly, try to budget and plan your purchases instead of falling into the trap of a marketing tactic.