How to Make Better Financial Decisions
How to Make Better Financial Decisions
By Adopting an Opportunity Cost Mindset
I’m not here to list the 7 best ways to make better financial decisions. It’s completely unnecessary. And odds are, you’d probably forget most things on that list after a few days anyway.
You don’t need a checklist of 10 different things to make better financial decisions. All you need is a different “financial mindset” and the ability to ask questions with regards to the purchases you make on an everyday basis.
And that mindset can be broken down and simplified into one easy rule of thumb: “Opportunity Cost”.
What I’m going to discuss isn’t a “secret”. It’s a simple economic principle and in many ways a common-sense way of evaluating your personal finances. It’s been adapted by the likes of Warren Buffet and countless others.
And for good reason!
It helps center you and helps you properly evaluate any financial decisions that come your way.
So, what is “opportunity cost”?
Oxford Languages defines opportunity cost as: “the loss of potential gain from other alternatives when one alternative is chosen”.
That definition may sound somewhat confusing, but it’s really not—once you break it down into plain English and provide some examples.
Let’s put it this way. Let’s say you applied for two jobs that are nearly identical; one job pays $25 an hour and the other pays $30 an hour. What position should you take? We should all unanimously agree: the one that pays $30 per hour is the right choice here.
Now let’s add more variables. Let’s say that the $30 per hour position also has a 1 hour commute each way and the odds of you being promoted seem somewhat slim, since management seems to be very locked in place. The $25 per hour position is a smaller company that seems to be trending upward and you have the added benefit of being able to work from home. You’ve already built up rapport with some of the team members and management.
What is the right decision in this scenario?
There might not be an easy answer, but if this position is in a career path you want to stick with, the $25 per hour position might be the better bet here.
If it’s not your permanent career path, you might lean more towards the $30 per hour position, since it will allow you to earn more in the short term.
This is how you evaluate the opportunity costs of any financial decision. By asking questions and trying to get an aerial 360 view of the impact your decision will have on your life.
We see consumers make the wrong financial decisions all the time. In 90% of these instances, it stems from an error in properly evaluating their money and not understanding how to implement an “opportunity cost” framework.
We’ve seen countless consumers contribute to a high yield savings account, while still paying a 25% APR on their credit card debt. This is wrong in so many ways! Although, having a money in a savings account may make you feel more at ease financially, it is not the right thing to do when you are paying an outsized amount of interest on your other obligations. This leads you to a false sense of financial security.
Why does this framework help us make better decisions? The simplest reason is that it forces us to ask questions that we may overlook or ignore.
Adopting an Opportunity Cost Mindset
Opportunity cost is originally derived from a very common economic principal. It stems from the idea that any business should always allocate its resources towards that which increases its productive capacity and towards an industry in which it is has a competitive advantage.
So how do you apply this principal to your finances?
It’s pretty easy. There are 2 steps.
- Ask Questions
- Treat your money like “a business” and always allocate your resource towards your productivity and highest earning capacity.
The more questions you ask in regards to your financial decisions the better you will be at adopting this practice.
The simplest way to help you adopt this mindset is by asking questions that will allow you to make better and more responsible financial decisions.
Let’s say you have a $1,000 in savings. You can either allocate that savings towards paying down debt, investing in the stock market or spending on personal leisure. There are multiple scenarios in which any of the above can be the right financial decision to make.
However, the most prudent order is to pay off any high interest debt you have, then invest your money and then spend on leisure. If your investments are fruitful, it may produce enough of a return to pay for any leisurely expenses a year or two down the road. So, patience is key here!
The order of priority for spending from people that make good financial decisions is as follows:
- Get rid of debt
- Invest for the future
- Spend on leisure
Why do some people make better financial decisions than others?
In many ways, taking out a loan can be a sure-fire way to “rob your future self”. However, that may not always be the case.
If borrowing money helps you achieve a long-term goal which will increase your financial security, it may be worth the risk.
If you are taking out a loan to go on a vacation. This is an all-around terrible idea. This is actually becoming a trend; these loans are referred to as “travel loans” or “vacation loans”.
Whenever you are borrowing money simply for “leisure” it is probably a very bad financial decision.
Psychologically speaking, borrowing money to “reward yourself” with a vacation also has the added effect of rewarding yourself for bad financial behaviors. This is the exact opposite of what you want to do and is a hallmark of individuals that make bad financial choices.
Opportunity Cost Mindset & Framework for Decision Making
Rome wasn’t built in a day. Take your time to make small changes every single day and get yourself out of your comfort zone. Something as simple as not purchasing a $5 beverage from Starbucks may not seem significant but any change (no matter how small) is always a move in the right direction. Change is often times scary but we all need to do our best to adapt. Implementing a small change can often times be the best way to make a small stride towards bettering your financial situation.