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Investment & Retirement Income Planner
14th September 2020
Opportunity Cost & a conversation with my wife!
A friend of ours called over to the house last weekend for a socially distanced glass of wine. This friend of our likes cars, specifically he likes new cars. He frequently tries to give me stick about my preference for driving older cars. As I shared in Blog 20, older cars are far cheaper to own than newer cars. The primary reason for this is that previous owners have already paid for the majority of the depreciation. And seeing as depreciation is often the single biggest cost of owning a car (far more so than insurance, tax, servicing and often even fuel), my preference is to avoid depreciation as much as is feasible!
Anyway, I was telling him how well the cars had been going – how little trouble they had given us over recent years. Murphy’s Law strikes and on Monday morning we have the jump-leads out as the family-wagon won’t start!! Following some car-seat juggling and frantic action everyone gets to school and work on time safely. The car needed towing to the local mechanic, and thankfully was repaired relatively inexpensively, and put safely back on the road quickly.
It’s 11 years old now – and in fairness it showing it’s age a little (the car, not Fiona!). It looks a little like the ugly duckling in the school car-park when parked beside some of the shiny new Peugeot’s and Volvo’s of other parents. So I wasn’t surprised when that evening Fiona expresses her frustrations about the family-wagon. Our conversation went something like this:
Fiona: We need to get rid of that car Paddy
Me: Eh why – we just had it fixed!?
Fiona: Because it’s 11 years old and looks like a crock, it’s done!
Me: But apart from that one break-down it’s spot-on; it’s safe, it’s serviced regularly and it’s perfect for what we need it for
Fiona: Yeah but it’s a crock!
Me: Fi, if you have the means to borrow or buy one, then anyone can drive a nice shiny car!
Me: Anyone can drive a new car – if you have the means, it’s only someone with a certain self-assuredness and inner self-worth that will happily drive a ‘crock’. It’s actually a valuable test of character!!
*Fiona throws eyes to heaven and goes back to doing what she was doing
Part of this is purely winding Fiona up in fun. Part of me believes that there is a lot of merit to it. I recognise that it is a bias of mine; I have always admired people whom are financially successful but didn’t feel the need to display that wealth. I admire anyone that has ‘made it’ that likes to wear their wealth – but I particularly admire those that don’t wear when they have it. Warren Buffet living in the same house he has since 1958 or so is a prime example of that self-assuredness. I’ve often reflected on why I admire that so much; my mother is the daughter of a Kilkenny farmer – maybe that’s where it comes from!! It is not meanness, it is deciding what it and what is not important – what the priorities and opportunities are. Money is finite, and so one euro allocated ‘here’ results in one euro less that can be allocated ‘there’. It raises the topic of Opportunity Cost.
Opportunity cost is loosely defined by Investopedia as the potential benefits an individual, investor, or business misses out on when choosing one alternative over another.
To help, look at this another way, as a calculation:
Opportunity Cost = Return on the best option not chosen – Return on the option chosen
Opportunity Cost traditionally relates to investment returns. For example, if I clear the mortgage I will save 3% in interest costs. If I invest it in ‘scheme x’ I will make 4% in growth. If I decided to clear the mortgage (essentially securing 3% return on those funds) instead of investing, the calculation would be:
Return on best option not chosen (4%) – return on the option chosen (3%) = 1% Opportunity Cost
However, Opportunity Cost is about emotion and other factors as much if not more than about financial for many decisions we make.
The Impact of One’s Decisions – Opportunity Cost
For context, I’ll share my own views on this mix of financial and non-financial factors by outlining our own Financial Planning.
I largely practice what I preach in Financial Planning. We have established financial goals that we work towards. The things that we have determined to be important to us are being saved towards or are established and monitored. The big ones being; kids’ education, diversified retirement incomes, preparation for different types of emergency, home upgrades, business planning and gifting.
Each month these priorities are being developed to one degree or another. Like most households we have a finite amount of income. We therefore allocate disposable income (after must-pays) to these goals on the basis of importance and urgency. You may observe that ‘driving shiny cars’ is not on the list of priorities, nor is it on the must-pays, so it isn’t given any priority. ‘The crock’ as Fiona referred to it as will continue to suffice until such time that it can’t physically continue to safely do its’ job. Relating that to the farming of the 50’s – you don’t change the Draught Horse just because it’s hair is looking a bit tatty – do you!?
If we for some reason decided to buy a much newer car it would mean we must allocate significant resources to do so. Let’s say an additional €500 per month in order to have a newer car. Which of our priorities would we stop or reduce our contributions to?
Applying the calculation to each of these three:
You will recall that Opportunity Cost = Return on the best option not chosen – Return on the option chosen
Opportunity Cost = Knowing we are OK, and being able to financially survive the majority of emergencies (MINUS) driving a newer car for a couple hours per week that might temporarily make us feel good
Verdict: Emergency Fund wins for me personally every time
Opportunity Cost = To have comfortably enough cash to pay for all education needs of our children, without having to rely on monthly incomes or loans (Minus) driving a newer car for a couple hours per week that might temporarily make us feel good
Verdict: Providing that education wins for me personally every time
Opportunity Cost = To be Financially Independent at a desired point in time, and with a desired retirement income level (Minus) driving a newer car for a couple hours per week, that might temporarily make us feel good
Verdict: Financial Independence wins for me personally every time
Of course, if the car dies we will act – it will become a ‘must-pay’ and we will be forced to allocate resources to it – but until then, the Opportunity Cost is just too high to do so. Likewise, something can happen to one or more of the pots to throw the plan off-course. We will deal with it if that happens – but we know that right now, we are doing the right things based on our own priorities, and we are deliberate in doing so.
But I Can Afford To Cover My Priorities, And Still Have Cash To Spare For Luxuries!
You probably aren’t interested in me telling you what you should or shouldn’t buy, or use your money for. What I do encourage you to recognise is the importance of spending and allocating resources to the right things. By right here I mean the things that really matter to you, not to someone else. If you absolutely have all of these priorities already boxed-off and still have spare change then great. It you feel that maybe you are missing something, here’s a thought.
Revisit you priorities. Really consider the things that, if given priority and funded accordingly, could bring huge satisfaction and positive impact to you and others. Some ideas to get the juices flowing:
Idea #1: Saving €500 p/m over next 10 years, at even 3% net growth would be just shy of €70k
Enough to gift to a loved-one, pay for their education, clear their or your mortgage early?
Idea #2: Savings €500p/m over the next 20 years at 3% net growth could be €163k
Enough to cover a few years’ expenses and allow you step back from work early
Idea #3: Saving €500pm for 2 years, at 1% growth could be €12k
Enough money to donate a meaningful chunk to a cause – take a few months leave, start a small business, go back to education, volunteer, whatever!
The amazing things is that many of us have so much opportunity – so much choice and freedom – but we (I include myself in this) fail to recognise these choices and to take positive action.
If we determine a goal that is deeply personal to us, we will then see IT as the opportunity. We will therefore allocate potentially ‘spare resources’ to this really meaningful goal. Yes, that may mean that ‘the shiny car’ or other luxuries go from ‘must pays’ to ‘maybe pays’. They may become less important in your eyes and you might drop them entirely. But what you are GAINING is the promise of things that will now hold far more meaning and far more value to you.
How interesting a world it would be if we measured success differently. Imagine if someone being able to take cherished time out of work, or gifting something impactful to a loved-one, or leaving paid employment entirely in order to volunteer were cherished as highly as the shininess of car they drove currently is.
Some day perhaps!
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