Generally speaking, people look at savings as a simple matter of putting away as much money as possible. It’s the money that one has right now that’s the core of the issue – how much of it needs to be spent versus how much of it can be put away for later. This is certainly one way to save money, but it’s not necessarily the most efficient way to build long-term wealth.
To build up wealth over time, one must not look at money as an end unto itself, but rather the means by which something may be accomplished. The key to building up savings is realizing the opportunity cost of spending and saving.
What is Opportunity Cost?
Opportunity cost is a function of choice. It is possible to think of it as the cost of doing one thing instead of doing another thing. At its heart, an opportunity cost is what you lose out on by doing one thing over another. If you spend a dollar on a candy bar, for example, you have not only reduced your savings by a dollar but also incurred the opportunity cost of being unable to invest that dollar. Likewise, saving a dollar carries with it the opportunity cost of being unable to use the dollar for any other purpose.
Opportunity as Growth
Businesses use opportunity cost all the time to determine how they will use money to grow in the future. Since every decision carries with it both a risk and a reward, it’s necessary to figure out which opportunities will allow the business to reach its goals. When a title loan company decides to lend, for example, it is determining that spending money (via the loan) is worth the opportunity to recoup that loan plus interest. A cost might be incurred, but it’s worth the risk to make a profit.
Look at Opportunities
As an individual, you can look at all of your decisions as a clash of opportunities. Spending money is not just spending money – it’s missing out on the opportunity to put that money to work. If you decide to spend a few hundred dollars on a night out, you’ve missed out on the chance to invest that money. A good opportunity analysis would allow you to see that investing the money now could lead to a greater payoff in the future. Once you subject all of your spending decisions to this kind of analysis, you can have a better idea of how your choices will impact your future.
The Value of Spending
One of the most difficult things to understand about opportunity cost is the fact that it is sometimes better to spend money than to save it. In this case, it’s because the cost of not spending is actually higher than the cost of spending. A good example might be buying a car. While purchasing a car is, on its face, a move that reduces one’s overall wealth, it carries with it the benefit of greater mobility. Failure to buy the car might have a higher opportunity cost if owning a vehicle is necessary for making more money in the future.
Opportunity cost analysis can allow you to determine not just how to save, but how to spend. Looking at your finances through this lens puts you in a position to determine what will help you to generate the most long-term happiness. Your savings will continue to grow as you realize that every chance you have to spend is also a chance you would have to save and invest.