I want you to remember two numbers: 4 and 8. These are numbers I think about every time I pull out my wallet to buy something, every time I enter a store, every cashier I see, or every “buy now” button that shines my way. These two numbers will transform the way you think about the money you are about to spend.
What we’re going to talk about is a concept I was introduced to at the young age of 17 that totally blew my mind. It’s opportunity cost. Sound familiar?
What is Opportunity Cost?
Opportunity cost is the concept that there is a cost associated with the expenditure of money beyond its face value because you could otherwise invest that money which would have made compounding returns for you somewhere else.
Example 1 – $10 Flowers
I have $10 and I walk by a shop and a see some beautiful flowers that I think my wife would love. They’re her favorite type of flower and her favorite color, nailed it. But then I take a second and think about whether I really want to spend that money or if it could go to something far more valuable in the future. How do I approximate the future value of this money if I don’t spend it. In this case, I multiply the cost of my good ($10) by the fixed values of 4 first and 8 secondly. This gives be numbers of $40 and $80 respectively. Those numbers represent the future value range of my $10 is I were to invest it.
When put this way, it seems really expensive to buy $40 and $80 flowers for my wife. She’s great and all, but I should probably just cook her a nice dinner for less because that’s excessive.
Okay, maybe the flower exercise isn’t convincing you of this logic. I think it’s powerful to look at these small items in this lense because it makes them seem so much more expensive, but let’s take a big ticket item and make it look gigantic.
Example 2 – $5,000 Vacation
You’ve always wanted to go to Switzerland and jump out of a helicopter onto a ski mountain. James Bond did it, you’re going to do it. The cost of this high-octane vacation will be $5,000.
Before you pull the trigger though, you sit back in your chair and think about that blogger who told you to stop for a minute and do some quick math before buying anything. So, you do some mental math and multiply $5,000 by 4 and then $5,000 by 8 getting $20,000 and $40,000 respectively. The real cost of your trip if you were to invest your money instead of bombing down a mounting would be, $15000 to $35000 additional dollars on top of the $5000 sticker price. This is because your money would work for you if invested instead of spent. But damn, a $40,000 vacation if my money does really well in the markets? That is insanely expensive, even for James Bond. Maybe I’ll go on the cheap and not jump out of a helicopter for $1,500 instead.
The quick and dirty here is that I assume that any money invested in a total index stock market ETF will return roughly 7% over time and that a balanced portfolio of stocks and bonds will return at 5% a year on average over the long run (30 years), but more on this in the next section.
Why do I believe in 5% & 7% long-run returns?
The long-run performance of stock indexes in the US are generally some of the strongest long run areas of return an investor can find. The S&P 500, for example, has returned roughly 8% on average throughout its long history since 1926. And even more diversified ETFs such as the total market fund VITSX offered by Vanguard has averaged well over 7% over it’s past 15 years.
These aren’t just out of thin air numbers that I’m putting together to sell you, there has been extensive research on the subject because so many people are invested in the market and want to ensure they’re well-diversified and investing profitably.
So given everything I’ve said, shouldn’t I be using 8% as a baseline for the growth of my portfolio? Probably not. It’s doubtful that every dollar you invest will go straight into the stock market. You’ll likely pick up bonds over your investing lifetime as well as a home or an investment property that provide lower returns than the stock market on average. So for me, I use 5% and 7% as long-run portfolio averages than just assuming every dollar I’m ever going to make will give me fantastic returns in the markets.
How do we get to the 4x and 8x multiples?
Let’s go back to our examples above. I said we could quickly multiply the cost of the thing we’re going to buy by between 4x and 8x to get a sense of how much it will be worth in future dollars. How come?
Using opportunity cost calculators you can see that that the at between 5% and 7% average annual returns (or interest rate) a dollar amount will multiply by between 4x and 8x. technically, it’s actually a little more – like 4.4x and 8.1x it’s original value.
If you’re interested in doing the math a bit yourself and playing around with some alterations to the numbers, such as different interest rates and time frames, you can use this Opportunity Cost Calculator to do the math yourself.
The main lesson within this post if I didn’t call it out strongly enough earlier is – don’t just spend money. Do some math first on how much money your spending is actually costing you.
Multiplying your costs by 4x and 8x every time you pull out your wallet can be tiering, but it’s really important that you quantify the future value you could be throwing away.
This method has helped me stop eating out from the office; has kept me from buying a car for travel purposes; keeps my monthly subscriptions lean; and is a consideration in where I choose to live. Don’t let the simplicity of the math fool you, spending is costly.