“There’s no such thing as a free lunch” – Milton Friedman
Opportunity cost is the net value (benefit minus cost) of the next best option that you have forgone by pursuing your actual choice. While you haven’t actually incurred this cost, if its value is larger than that of of your actual choice, you have made a bad choice!
As humans, we sometimes make bad choices. We struggle to evaluate happiness, money and time. I have built this calculator to help you explore this relationship. After you enter some basic details about a choice you have to spend or save, the calculator will extrapolate out the value of investing this saving for an extended period.
With this information at hand you’ll be better equipped to decide whether buying that cool new gadget or second coffee for the day will bring you enough happiness to outweigh the true financial benefit that you’ll forgo.
DISCLAIMER: Please note that this article and associated calculator is only intended as a thought exercise and is not financial advice. Any reference to a particular product or investment instrument is purely for illustrative purposes and not a recommendation to purchase or not purchase. Anyone seeking to invest should consider their own unique objectives and constraints before making any decisions.
This calculator assumes that all saved money from “forgone happiness” is invested and that the income from this investment is reinvested annually until the nominated end date.
Further explanation of compound interest, inflation, Modern Portfolio Theory and Exchange Traded Funds (ETFs) is included below.
The Hash Brown example
The 31 year old Melburnian foregoing a $5 side of hash brown at brunch on a Sunday morning.
My partner and I now have a rule. I sit down hungry… I will then proclaim to the waiter that I’ll have my nominated meal with a side of delicious hash brown. My partner will glare at me and I will cancel the side. It’s brilliant because when I do order the side, I always feel way too full by the time I’ve completed my meal.
Let’s assume I plan to retire at 65 and invest in an ETF (see below). Here’s the break down…
Utility forgone: Delicious hash brown and slight sickness from having eaten too much.
Actual dollar value: $110.43
Inflation-adjusted dollar value: $47.70
So what will $110.43 buy when I’m a retiree? Our best guess has it at whatever $47.70 will buy today. $47.70 will go very close to getting two people some brunch with a juice and coffee.
Did I really want that hash brown or second coffee anyway? We make small decisions like this all the time and they have the potential to add up over the course of a lifetime. It’s not to say you should treat yo’self, but just think about if you really want it!
“My wealth has come from a combination of living in America, some lucky genes, and compound interest.” – Warren Buffett
This calculator assumes that all returns (i.e. income or dividends) of your investment are reinvested annually. In the case of ETFs (see below), they generally offer a dividend reinvestment plan that enables you to compound your returns, without needing to pay brokerage fees.
The power of compound interest comes from earning a greater total return on the same rate of return with each period that the profits are reinvested.
The Consumer Price Index (CPI) measures how much prices have risen each year and can be used to understand purchasing power. If the price of Big Mac rises by 3% and your bank account is only giving you 2.5% interest per annum (p.a.), then the savings in your bank account will be able to purchase fewer Big Macs this year than you could last year (i.e. your purchasing power has reduced).
This calculator computes both the actual (nominal) and inflation-adjusted (real) value of your investment. Both values are important to understand, but pay particular attention to the inflation-adjusted value, as a Big Mac will be far more expensive in 30 years time!
Just like expected company profits (see below), inflation is notoriously difficult to predict. For the last decade, economies around the world have (and continue to) exhibit lower inflation levels than historical averages. No one knows whether this will remain permanently low or if inflation will restore to normal levels. For this reason, the Hash Brown example assumes the middle of the Reserve Bank of Australia’s 2-3% target range for inflation (i.e. CPI of 2.5% p.a.).
Modern Portfolio Theory
Sounds complicated, right? The long answer, yes. The short answer, no. Modern Portfolio Theory asserts that you should diversify your investments to reduce risk.
When it comes to protecting yourself against the impact of a recession, keeping some cash deposited in an Australian Government-guaranteed financial institution is a way to ensure you have access to money at the touch of a button. Unfortunately, the interest paid on “high interest savings accounts” is not all that high, especially when factoring in inflation (see above).
As a result, splitting your investments between cash, shares, direct investment (e.g. private ownership in a business) and property can provide you with a blended level of returns, risk and liquidity.
However, you can take diversification one step further and spread the risk/return further. In the case of cash, it might involve keeping some cash in a second bank. This way, if there is a massive IT outage at one bank, you can still access your money from the other bank.
Now, let’s look at shares. It’s not easy picking winners. Share prices are a reflection of the market’s expectation of each company’s future profits. Participants in the market form expectations of future profit based on publicly available information. Expectations are probability-adjusted averages – they take into consideration the likelihood and outcome of “ambitious” and “everything goes wrong” scenarios (as well as every other possible outcome). However, companies do not pay expected profits – they pay actual profits, and these two can differ dramatically.
To reduce the volatility of your returns, your best strategy is to spread your exposure to a greater number of industries and companies. This is akin to rolling a dice 300 times, instead of just 6 times. This repetition helps increase the chance of you getting a real world result that is closer to the “expected profits”, which is an equal proportion of rolls one through six, in the case of die rolling.
However, investing in 300 companies (i.e. the 300 largest companies in Australia) can be expensive and time consuming, as you will be constantly calculating and trading. Exchange Traded Funds (ETFs) are one way to get the desired diversification, without costs associated with doing this yourself.
Exchange Traded Funds (ETFs)
ETFs are holding companies that buy and sell a portfolio shares, meaning that by purchasing one share, you are actually purchasing a proportion of each share in the basket. Each ETF maintains the balance of its basket in line with its own recipe. Unlike managed funds, however, an ETF’s recipe is set in stone and often tracks a well established index. Trading in a single share keeps your own transaction costs and time for analysis low.
Further, the “management fee” of ETFs generally range between 0.1% and 0.3%, meaning that more of the return stays in your pocket. By comparison, managed funds performing the same tracking function charge closer to 1%.
If you are after a fund that doesn’t track, but attempts to pick winners on your behalf, this management fee can rise to well over 1%. And if you think that this cost is an investment in expert knowledge, have a listen to this Freakonomics episode.
So, back to the calculator. The ETF used (see below) is just one of many available to buy and sell on the ASX, so you still need to do your research. Do you want exposure to Australian or global markets? Are you more interested in capital growth, income or a balance?
Without going into too much detail, by saving some of your salary and adding to your ETF portfolio in blocks that minimise brokerage costs, you can build a share portfolio that minimises risk. If you are prepared to sacrifice the enjoyment of the income produced by your portfolio, you can use a dividend reinvestment program to capture the benefit of compounding interest.
The Vanguard ETF example
The Vanguard Australian Shares Index Fund ETF (ASX: VAS ) benchmarks the S&P/ASX 300 Index, meaning it holds a weighted basket of the 300 largest companies in Australia. It offers a dividend reinvestment program and franking credits (something not factored into this article)