If you woke up this morning and thought, “wow, I’d really like to read about some economic theory,” then, one, that makes two of us, and two, you’re in luck! In this post, I’ll talk about the concept of opportunity cost, which, although it may sound a touch academic, is actually quite relevant to many of the decisions you make – especially with respect to saving and investing for retirement and FIRE.
What is opportunity cost? Plain and simple, it means the cost of doing one thing over another. When you perform one activity, you are foregoing the opportunity to do something else. Does that sound a little obvious, or maybe, roundabout?
Let’s put it into figures.
Start with the premise that opportunity cost captures the fact that not only does what we choose to do have a cost, but there’s an additional cost of foregone opportunity. Say it would cost $100 to have someone clean your house for you. Alternatively, you could clean the house yourself, and it takes 2 hours to do so. If you choose to do it yourself, you don’t pay the $100 out of pocket, but you do spend 2 hours of your time. The opportunity cost is what you could have done with those 2 hours of your time instead of cleaning. If, for example, you would have been able to spend those 2 hours doing some sort of work that would generate revenue for you of $200, that’s the opportunity cost of cleaning the house on your own.
The point of the example is that there are costs to our choices that we might not consider. In the above example, you might think you’re saving money by not paying $100 out of pocket to a house cleaner, when in reality, because the opportunity cost is higher than the out of pocket cost, you’re actually (in theory) worse off because you squandered the chance to earn more in that time than you would have spent. Had you hired the cleaner and worked, you’d be up $100 ($200 earned minus $100 spent = +$100) for those two hours, but because you spent those 2 hours cleaning, you’re down $100 ($200 foregone plus $100 saved = -$100) because the opportunity cost was greater than the out of pocket cost.
I hope this simple mathematical model illustrates the point that there are other considerations when determining how best to allocate your time and spending. Let’s get a bit more theoretical. Take the above example again, only this time, don’t assume there’s something you could do that would earn $200 in those 2 hours. You’re tapped out at work and you don’t have some freelance gig you can work on. Now, there aren’t clear numbers to make a calculation. (Assuming that you walk around calculating costs all day).
Instead, the calculation becomes more subjective: do you value the 2 hours of free time that you get by not cleaning the house over the $100 you have to pay someone else to do it? That is, are the 2 hours of liberation worth more than $100? There’s no clear math to go by here so it comes down to subjective value to determine the opportunity cost.
Do you spend every moment of your life glued to your e-mail and screen with hardly a chance to breathe, such that these two hours represent the only chance you get to sit in front of the tv and escape? In this case, it could be pretty clear that a little free time is worth the $100. Or, do you sit around all day not doing anything such that another two hours of free time has little value? In this case, maybe it’s not worth the $100 and you should get up and start scrubbing. As you see, the opportunity cost differs depending on the person and the circumstances.
While this is just a simple example, the concept of opportunity cost pervades our lives. When we do one thing, we can’t do another, and there’s a relative cost to both. So what does this have to do with FIRE? Quite a bit, actually.
Opportunity Cost and Retirement
Retiring early involves a critical decision with respect to opportunity cost. By choosing not to pursue a wage-earning vocation at whatever age you “retire,” there’s a significant opportunity cost trade-off. On the one hand, you’re gaining freedom from a predominantly wage-earning lifestyle, while on the other, you’re foregoing the wages and associated benefits that come with working. Put simply, when you retire, the lost opportunity cost is the cost of not working.
You might be saying: “well, yeah, that’s why I’m reading this to begin with…who cares about the underlying economic theory?” And to that I’d say: you’re right – the economic theory underpinning your choice is not important. But, I’d add that there’s more to it that you might want to consider, both for early retirement and for getting there.
Yes, when you retire, your opportunity cost is the cost of not working. If you decide that retirement is the better option for you, you’ve decided that both the economic and subjective freedom are more valuable than the wages, etc. that you’re foregoing by no longer working (or working in the job from which you retired). This is economic principle come to life – you, the rational decision maker, have weighed the pros and cons and made a decision suited to your circumstances.
Opportunity Cost Getting to Retirement
The concept of opportunity cost does not apply merely to the decision to retire; it comes into play in the decisions you make to get there. As we know, a critical part of FIRE is the saving you need to do. Compared to someone pursuing a more traditional retirement track, the FIRE investor saves a larger portion of their wages during their working years. Again, there is opportunity cost to doing this.
If you receive a paycheck for $2,000 at age 35 and decide to put $1,000 of that into a brokerage account, you’re foregoing the opportunity to spend that money when you receive it. This might mean that you willingly live in a smaller house or apartment, drive a less expensive car, forego new clothes, etc., whereas the person who spends more of their paycheck might now possess these more expensive things.
In comes temptation. Seeing others with more space, more modern appliances, a newer car, and so on, especially when those others may be earning the same – or even less – can bring about the urge to abandon your longer-term goals. It’s simply human nature. FIRE requires a certain dedication, but we’re all human, and it’s only natural for our subconscious to see things that we could have and end up wanting them for ourselves.
But, think of opportunity cost (and let economics reassure you, as I do every day). Your friend’s calculation of opportunity cost is simply different from yours. To them, the calculation resulted in a higher subjective value to having certain things now instead of a larger pot of savings. But there’s opportunity cost to those decisions. The opportunity cost to spending more of their paycheck on housing, cars, etc. is foregoing greater freedom from wages later in life. So you could say that because they’re spending more now, they’ll have to work longer later to afford it.
Hopefully by understanding this, you can talk yourself down from the temptation to deviate from your FIRE goals. If you’re a FIRE saver, you’ve placed a higher value on your time (which remember, is a non-renewable resource) than certain comforts in your working years. And remember, there’s nothing inherently wrong about placing higher subjective value on one or the other; rather, it comes down to a matter of personal preference and value. So don’t be tempted by that extra bedroom or newer kitchen countertop – remember to stick to your judgment that time has a greater value.
Other than allowing the concept of opportunity cost to reassure you that you’ve made an appropriate decision to pursue FIRE in the first place, there are more considerations for the FIRE saver in the years in which you’re building up your nest egg.
Remember the concept of trade-offs. FIRE undoubtedly involves some major trade-offs in the way you live your life. But, as I’ve stated before, one thing you want to avoid is living a life that trades off too much, particularly when some trade-offs might be unnecessary.
Consider the example at the beginning of this post when you’re trying to figure out if you should clean your house on your own or hire someone to do it. It might seem logical, if you’re trying to save as much money as you can, to do it yourself. But again, remember that while you’re scrubbing the toilet, you’re not doing something else – something that could be earning you more money than you spend.
Even if, however, there’s nothing else you could be doing that would earn you more cash than the money you’d spend on hiring someone, think of the subjective value. If you’re pursuing FIRE, you’re already foregoing many other things by saving rather than spending large chunks of your income. Perhaps then, the little downtime you earn by hiring someone to clean increases in subjective value in your opportunity cost calculation.
Think of it this way – you don’t want to forego so much that it become unsustainable. And that’s really what you want to avoid – if you’re pursuing FIRE, you have to find a sustainable balance so that you don’t give up. (There’s nothing wrong with cleaning your house – I’m merely using this as an example of a chore. Pick any other chore as you see fit).
The same might apply to tangible items as well – saving money all the time either by foregoing purchases or buying the cheapest items can land you on the wrong side of the opportunity cost equation. Would a newer, more expensive stove motivate you to cook at home more often, thereby saving you money that you’d spend eating out? If you save $300 dollars on a stove, will that result in you ordering more takeout? The answer is not the same for everyone, but it’s something to consider. Remember that the opportunity cost of saving that money means you might be missing out on the opportunity to cook yourself (the inverse of the cleaning issue).
Think of other trade-offs. Would a better coffee machine keep you from spending $5 every day at a coffee shop? Would nice in-home exercise equipment motivate you to work out and keep you from spending monthly dues at a gym? In each case, there may be a greater longer-term value to your money by spending more now because it will allow you to do other things that eventually save you more money. The unintended result of saving money now might be higher spending later.
To be clear, I’m not advocating for wasting money, nor am I saying that you can use opportunity cost as an excuse not to save. What I’m saying is that if you consider opportunity cost when evaluating trade-offs, the initial answer as to what’s more prudent may change. Getting to FIRE is not always about minimizing out of pocket cost in the moment so that you have more to save – it’s about longer-term, sustainable decision making that gets you to think about how you maximize value over time.
Think of it this way: FIRE is not, as you may read in some places, all about living as cheaply as you can, whether that’s cramming a four-person family into a converted shipping container or driving a car where your knees hit the dashboard or eating what sprouts from your compost pile. To achieve FIRE, there will be times when you have to go against your natural instinct and choose to live more frugally. But you shouldn’t think this means you have to give up everything. For one, it may not be sustainable, meaning that you eventually give up anyway, and two, that might not be the life you want to live.
FIRE cannot be a goal in and of itself, because what’s the value in that? FIRE has to be part of a greater series of goals aimed at improving your overall living situation, one of which (a major one) is allowing for greater flexibility with your time. You probably don’t want a situation where you’re free all the time, but you spend it in cramped quarters with nothing to do.
So when deciding whether and how to spend money, and whether, when, and how to save money, consider the alternatives. Think about opportunity cost – what are you foregoing when you make a particular decision, what is the cost of the alternative (out of pocket and subjective), and determine what is more likely to give you the greater long-term value.
So long as you can keep some control over your subjective whims, a more reasoned approach – one that accounts for economics (yes!) – can help you balance your lifestyle as you save and invest toward early retirement.
The FIRE Investor's Guide to Early Retirement 