12 Sep 2014 You Have Far More Wealth Than You Realize
The financial decisions we make on a daily basis, even some relatively small ones, can have a huge impact on our future. That’s because of the power of compounding. We understand that a relatively small sum saved over time can grow into a very large amount in the future. But we rarely recognize how compounding can work for or against us in our purchasing decisions, which are more frequent and significant than savings decisions. This is an area where the concept of opportunity cost can be especially helpful.
Opportunity costs are what economists define as any benefits we give up when we acquire, achieve, or hold something else. Because we are impulsive by nature, we rarely stop to consider opportunity costs which requires more objective thinking. For most of our personal buy decisions we are under the control of our emotions, not our logic. These decisions over a lifetime play a much greater role in our future lifestyle than we realize.
Let’s take a hypothetical husband and wife in the TV department of a store. He is on fire to buy Samsung’s new 65″ 1080p 3D Ultra Slim LED Smart TV with dual screen viewing. ‘It can be ours for only $1,999’ he says excitedly. But his frugal wife points out that if he was willing to reduce the screen size by a mere 5″ he could get the same model for $1,400. The math whiz might add that’s $120 per inch, but our wise wife understands that she’s not going to quell her husband’s buying frenzy by talking in mere dollars. He’s imagining hours of football, basketball, and action movies. So she calmly suggests, ‘you know dear, with the savings of $600 you could have that sports package you’ve wanted for the next couple of years or you could buy as many as ten extra movies a month on Amazon Prime for the next year.’ His wife understands opportunity cost.
But in the framework of real lives, we’re talking peanuts as far as big screens go. While the small transactions add up over time, there are major ones that are too easily overlooked, such as cars, houses, and investing.
The average American buys ten cars during his or her lifetime, most often with financing. A new 2014 Honda Accord runs about $32,000, while a 2-year old dealer-certified Honda Accord can be had for about $18,500. Practically speaking, both cars will perform similarly during a 5-year ownership period so there is little utility difference. We can measure the opportunity cost of buying a new Honda or a used one in dollars, but as we have seen in the TV store, dollars don’t speak to us like our preferences and emotions do. Opportunity cost is in the imagination of the beholder.
If the cars were financed for 5 years at 5%, the difference in annual payments between the new and used would be just over $3,000 a year. That opportunity cost for one couple might be whether or not to send a child to private school in Raleigh. Another might want to dine out more often or upgrade their vacations, maybe even renovate.
But what if these couples took a longer-range view and considered how improved retirement could be an opportunity cost of buying new cars? By buying a two-year used car instead of a new one every five years from now on and investing the annual difference in financing costs, ($3,060) until retirement, they would have substantial options available to them at age 63 and beyond. For instance, they could boost their household spending or travel by $25,000 annually (increasing with inflation) for the rest of their lives in retirement. They could leave $300,000 more to their children. The options for the additional $25,000 per year are limited only by their imagination, should they seize the opportunity rather than cost it for that ‘new-car smell’ every five years.
Another significant store of value where opportunity costs may exist is in the homes of older couples whose kids have left vacant rooms and play areas that only store furniture and collect dust. We are amazed when we stop to consider how little space in our homes we actually use most of the time. And when we substitute other creative and exciting alternatives for those special, but infrequent family gatherings and large-scale entertaining, we are freed to consider the opportunity costs of maintaining such large homes.
Consider Bob and Carol Jones, 50 years old in their $800,000 house. They determine that 40% of the home is not used often enough to justify the expense of keeping it. Through this simple exercise they have identified an opportunity cost of $320,000 today, plus tens of thousands more in ongoing maintenance, taxes, and financing expenses that drain their wealth. But what’s the cost in real life terms?
Bob and Carol borrowed $500,000 twenty years ago at 5% to buy their dream home for $550,000. Today, they have a remaining mortgage balance of just over $250,000. By right-sizing to a $500,000 home for cash, they would eliminate $32,000 a year in mortgage payments, $3,750 in property taxes, and $3,000 in maintenance expenses. In dollars, the opportunity cost comes out to $38,750 for 10 years (remaining mortgage term) and $6,750 thereafter, in today’s dollars.
The Jones’ want to work another 10 years before retiring. Comfortable with their current spending, they opt to invest the savings from their ‘right-sizing.’ into their Balanced portfolio (60% stocks and 40% bonds) to enhance their retirement and estate options ten years from now – and enhance they do. Bob and Carol’s financial advisor at Beacon shows them they can increase their after-tax spending by $23,500 per year for life (increasing with inflation), they can improve the inheritance they leave to their children by $3.35 million, or they can achieve any other combination of goals they take the time to imagine.
At Beacon we go on and on about how investing with active managers is a losing proposition over long periods of time. We make allowances for professional investors who are good at what they do and devote considerable time to their activities. But the vast majority of investors do so for distant goals that have nothing to do with the investing itself. We often point out Dalbar’s annual studies of investor behavior which consistently reveal that people sacrifice as much as half (4% – 6%) of the returns available to them in the capital markets. Just this week S&P released their study showing that over the past 5 years 75% of all domestic equity managers failed to beat their index benchmarks. And the same was true for international equity funds.
As the lion’s share of the funds represented by these studies are invested for real-life purposes like education, retirement, and the passage to the next generation, the shortfalls represent huge opportunity costs in lifestyle. Continuing the example of Bob and Carol Jones, just a 2% reduction in their fund performance reduces their retirement spending from $90,000 annually to $55,000. In our business, we know of no worse financial opportunity cost than needless lifestyle sacrifice.
At Beacon our entire process is focused on maximizing the lifestyle of our clients through a continuing process of identifying threats and opportunities. One of the best techniques available to improve decision making and planning is the concept of opportunity cost. But it is not a natural instinct. We have to consciously work at it and it helps to have objective counselors to point out the costs we often fail to recognize when our emotions are in control, as evidenced by the wife in our TV example.
The stakes go up geometrically when we begin to consider decisions that have huge leverage on our future lifestyles These are decisions that we want the best advice from counselors with the best tools and experience to help us identify and measure opportunity costs every step along the way.