Our teens and twenties are supposed to be fun and carefree; that time in life where we don’t have to think about the future. Unfortunately, that is also the time where it is both the easiest and hardest to start accumulating wealth. Between education costs, low starting wages, getting married, buying a house, and raising a family, a lot of people have to bootstrap their life during this point.
The thing is if you save during this point in your life and are intelligent about your investments, this is the easiest time to set a course for financial independence. Tough thing is you need money to save, and it seems like there is never any lying around after paying all the bills, thus it becomes a circular problem. Harsh deal, I know. Welcome to the opportunity costs of youth.
Opportunity cost is the idea where you measure the life utility of a course of action you are going to take. Do I want X or do I want Y? Should I put this money into an extra payment for my mortgage, or should I put it into retirement? Should I put this part of my paycheck into my vacation savings, or should I go out with friends and order a better vintage of alcohol than I normally get? Should I put this dollar into my kid’s college fund, or do want to use it for poker night? Those are the questions that go into opportunity cost. I should make a special note though that opportunity cost isn’t just financial, it is also emotional and includes other variables that you have to take into account. Opportunity cost is about making the best informed decision you can about what is going to make you happiest.
Back in high school, I remember those semi-formal competitions about who had the nicest car. The girls swooning as you drove by, well, the daydreams of that happening were nice. The dates and independence that came with a car. Everybody hungered for the day to be able to drive their own car. None that I knew stopped to calculate the costs.
One of the common arrangements between parents and children at the school where I went was that the parents would buy the car with the teenager putting up some of their money, and then the teenager was liable for gas and part of the insurance. For our hypothetical example of option A: let’s say the sixteen year old teenager, let’s call her Jen, put up $4000 for the car, and pays $50 a week for gas and her share of the insurance payment from her savings from her after school job. From that point on Jen owns a car. What’s the opportunity cost of this though? Let’s look at option B. Instead of buying a car, Jen takes her paycheck and invests it in a Roth IRA in an S&P 500 index fund.* Let’s then say Jen will retire at the age of 65. How much money will she have in her account at the end of that period then? According to the research done by Jeremy Siegel at Wharton School of University of Pennsylvania, and the gold standard Ibbotson Associates, the S&P 500 index returns about 10% annually over long periods of time. So using what we know we can see that in 49 years Jen will have 4000 x (1.1^10 x 49) = $508,373.52. Jen has half a million dollars then and I haven’t yet calculated the annuity of her gas and insurance payments! Let’s use an ordinary annuity to lower her return a bit. Since she has $2600 at the end of the year (50 x 52) her annuity will have a value of $2,748,692.88. The amount of money Jen has at the end of the period is $3,257,066. If the S&P is yielding 2% at that time she will get $65,141 the first year she retires, and that figure will grow over time. To have your cake and eat it too that money will be tax free!
At the same time, Billy, a friendly 22 year old at a frat in college, has built a habit of spending about $400 of his paycheck a year on beer, is also giving up a lot. By spending $400 for beer every year, using an ordinary annuity, we see that if Billy put that $400 a year into a retirement account he would have $236,960.
“Ok,” you say, “what’s the point of this? I like my car, and spending my money on beer.” My response, “Great!” The point of this article isn’t to tell you what you should spend your money on. The point is to give you some tools so that if you are in the position of Jen you can ask yourself, “Which do I want more?” Is it a car or 3 million dollars when you are 65? Maybe you compromise, and you get a more fuel efficient car to cut back on gas, or a cheaper car. The huge thing about being young is how much value a dollar has. Financial opportunity cost decreases significantly as you get older because, as more time goes by, your dollar has less time to compound. Opportunity cost is all about making educated choices about what you value most. The horrible thing about our education system is that it doesn’t teach us how much value a dollar has when we are young, and that it is when we are youngest that it is easiest for us to become financially independent.
*I cheated a bit with Jen’s car calculation because the current Roth IRA contributions in fiscal year 2014 when I wrote this was $5500 so Jen would have had to place $1100 dollars outside of her Roth. If she put it in another retirement account then that money would have grown tax free to the same amount, but when she retired she would have had to pay taxes on those gains.