Opportunity Costs

Opportunity Costs

A choice uses resources that could have gone elsewhere. Looking beyond its immediate benefits means asking what you must give up to obtain them.

The real world is full of trade-offs, some of which are obvious, and others that are hidden. An opportunity cost is the value of the best alternative you give up when you make a choice. It may be obvious or easy to overlook. Because we can’t always do everything we want, picking one thing usually means forgoing another. Making the alternative explicit helps you assess whether the choice serves your priorities.

Charlie Munger put it this way: “Intelligent people make decisions based on opportunity costs … it’s your alternatives that matter. That’s how we make all of our decisions.” Warren Buffett echoes the same idea, noting that the difference between successful and really successful people is that really successful people say no to almost everything. By understanding what you must forgo, you can protect your finite resources—money, time, energy—for the options that truly align with what you value.

One of my favorite examples of this is a story about Andrew Carnegie. When Carnegie was young and relatively inexperienced in his job at the Pennsylvania Railroad, there was a bad train wreck that left train cars strewn across the tracks and gridlocked the entire system. Carnegie’s boss was absent, so Carnegie himself had to decide how to handle the event. Cleaning up the cars would save much of the cargo, but it would be a long and costly operation and would suspend all train traffic for days. Carnegie realized that a multiday system-wide shutdown wasn’t worth the cost of the cargo and the cars. He sent a bold note signed in his boss’s name: “Burn the cars!” When Carnegie’s boss learned of his choice, he instantly made it the routine method of dealing with similar emergencies in the future.

The cost of a choice becomes clearer when you compare it with a feasible alternative, including the benefits that alternative would provide.

There are two principles concerning opportunity costs. The first is this:

THE OPPORTUNITY-COST PRINCIPLE: Consider what opportunities you’re forgoing when you choose one option over another.

The second principle is closely related:

THE 3-LENS PRINCIPLE: View opportunity costs through these three lenses: (1) Compared with what? (2) And then what? (3) At the expense of what?

For most of us, the first lens is our default because the costs are direct and visible. For instance, think about purchasing a car. If you’re like most people, you can narrow the decision down to a few options pretty quickly: “The Tesla will look extra cool and be fuel efficient, but will it be good for road trips? A BMW looks great and has more cargo space, but is a gas-powered vehicle behind the curve? Should I get the car that’s $42,000 or $37,000?” When we compare the two models, we focus on what the additional $5,000 gets us in terms of features, and forget to view the choice through the other two lenses.

When we view the choice through the second lens, we consider the additional costs that will arise after we’ve selected an option—for example, how we’ll need to charge the Tesla, its anticipated yearly operating costs, its durability, and how many long drives we’ll go on annually. When we view the choice through the third lens, we consider what else we could do with that $5,000. Are we giving up a family vacation? What about the dividends we could get if we invested it? What about the savings if we pay down the mortgage? What about a rainy-day fund in case we lose our job? Looking through all three lenses helps us make a better decision.

Money is not the only opportunity cost to consider. It’s just the most direct and visible, and for that reason people tend to focus on it. They convince themselves that what’s easy to see is all that matters. But in many cases, the real value to thinking through opportunity costs is to understand the indirect hidden costs.

Time is not as easy to see as money but it’s just as important. Suppose your family is growing, and it’s time to move. Relocating to the suburbs will get you a bigger house with a bigger yard for the kids, and it’ll be cheaper than buying a smaller duplex downtown with a backyard the size of a postage stamp. In this situation, many people think of how much money they’ll save by moving to the suburbs, and get caught up in the happy thought of walking across the threshold of their new home for the first time. But this way of thinking views the situation through only the first lens. It doesn’t disclose the less obvious costs of living in the suburbs. When we apply the other two lenses, we start seeing those costs more clearly.

Let’s apply the second lens. Suppose you buy that house in the suburbs. Ask yourself, “And then what?” How will your circumstances change if you choose that option? For one thing, your commute might be different. Perhaps it goes from a predictable half hour each way to an unpredictable hour and a half.

Now apply the third lens. Ask yourself, “At the expense of what?” What are you not going to be able to do because you’re spending an extra two to three hours a day in transit? Will you spend less time with your kids and your partner? What will you miss out on by not being with them? Will you be able to spend the commute learning a new language or reading some great literature, or will you have to deal with the frustration and stress of driving? Over time, which option is better for your mental and physical health?

Because opportunity costs are often subjective, it’s crucial to be clear about your objectives and what you truly value. The real cost of a forgone alternative isn’t just a number on a spreadsheet—it’s the loss of whatever you care about most, whether that’s family time, health, learning, or peace of mind. Aligning your evaluation with your deepest priorities prevents you from optimizing for the wrong things.

TIP: If you’re having trouble assessing opportunity costs, it sometimes helps to put a price on them. For example, putting a price on those extra two to three hours a day spent commuting will make them more visible and easier to assess.

Keep in mind, though, that pricing things whose costs are difficult to assess is just a tool. Like any tool, it’s useful for some jobs, but not useful for all. It’s an attempt to make the invisible visible. Sometimes there are important factors that you simply can’t put a price on without grossly distorting the trade-offs. As Einstein is thought to have said, “Not everything that can be counted counts, and not everything that counts can be counted.” For these “priceless” factors, describe the tradeoff directly and judge it against what you are trying to achieve.