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Finance

Finance

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Opportunity Cost

A lot of what happens with money comes down to choice. You can choose to buy a Porsche (assuming you have the cash for it), or you can choose a less expensive car. Or (the horror!) you can just use public transportation. You can choose to buy gummy bears, a cat, a pack of razors, or a bow and arrow for your Daryl Dixon zombie hunter costume.

When you have a fistful of dollars (or a briefcase full of them, if you're lucky) what you have are opportunities. You can buy almost anything with that money. Marketers know it and are always suggesting things you can buy with your money and coming up with new stuff for you to spend your cash on. Self-tying shoes (in case you get too tired to bend over, we guess)? Got 'em. Diamond-encrusted cell phone cases? Someone makes them.

Bottom line: you have lots of ways to use your money.

The Road Not Taken

But what about the stuff you don't buy and the ways you don't spend your money?

Trust us.

Every time you make a choice with your cash, you're eliminating other choices. If you buy a Porsche, you're probably not getting the Chevy (unless you get both). If you have $8,000 for a car and decide to buy a used car rather than investing the money, then you give up on the idea of investment (for now) and the money you could have made from that.

Captain Kirk and Captain Picard can hop over to an alternative dimension to see how their choices worked out, but you probably can't (unless you have a time travel machine in your basement). So before you make a decision about how to spend the money you've worked for, you're going to have to figure out what your best options are.

Here's the classic example:

You call in to a radio show and win two Super Bowl tickets. You bring your best friend, natch, and while you're there, the guy in the row behind you asks (not so politely!), "How much did you pay for your tickets, punk?" You (very politely) reply, "They were free!"

Wrong.

They were not free.

Why not? Well, look at it this way: what if you'd turned around and sold those two Super Bowl tickets on Stub Hub? You might have made a few thousand dollars off the deal. So when that guy asks you how much your tickets cost, the correct answer is "They cost a few thousands bucks." Yep: you could have had $2,000, and instead you have $0. Those seats cost you $2,000.

That's opportunity cost.

Weighing Costs

Let's say that you have $8,000 that you can either spend on a lemon of a car or invest. Both are a risk. You could hurt yourself driving, the car could stop working, or the car might get stolen by aliens in a shiny spaceship.

Instead of risking aliens and car trouble, you could invest in a generic basket of equities in the stock market—buying an index fund of the S&P 500. The major ones. Google, Heinz Ketchup, Coke, Ford, and so on.

Let's say that you pick well (even without that time machine in the basement) and you get 10% gains a year, on average, for ten years. After 4 years, the market is 40% higher. We're going to ignore taxes and commissions for now to Shmoop-rough this example, so that gives you $3,200 in gains or $11,200 in your sock drawer after four years.

If you decided to buy that car off Craigslist instead of investing, the $11,200 you could have earned investing would be your opportunity cost: the road not traveled, the path you didn't take.

If you got the rust bucket of a car and had the time of your life taking road trips with it, that may be a good choice for you. Maybe you managed to have your cake and eat it too. For example, maybe you bought the rust bucket and decided to lease it or put ads on it for local businesses, creating a little startup that nets you $10,000 at the end of four years because of your amazing business skills. That's low opportunity cost—you didn't give up much by taking the alternative.

But what happens if that car breaks down a week after you drive it off the lot and can't be fixed? You're out $8,000 (plus whatever the local tow company charged you to take that heap of metal off the road) and you're not going to gain anything out of investments. To add insult to injury, you now have to schlep to work and school on the bus because your wheels died. Suddenly, the opportunity cost starts looking pretty high.

Unless you're a psychic to the stars, you don't know how your financial choices will work out. That doesn't mean you can't weigh the pros, cons, and costs before you make big decisions with your money.

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