In this article, I will be explaining and discussing the theories of compound interest and opportunity cost. I believe that if we were all made aware of these two concepts at an early age, it wouldn't only make us better investors, but help us make better financial choices.
How To Invest: The Theories of Compound Interest and Opportunity Cost
What is opportunity cost?
Opportunity cost is defined as the benefits that an individual will forego by choosing one alternative over another. This theory applies to a world of finite resources, where you have to choose a specific product or service vs an alternative. In a crude example, if you only have 50p to purchase a snack, by buying a chocolate bar, you miss out on buying a banana. Opportunity cost tends to look at the implications of choice, so in this example, it is not just limited to the taste satisfaction of chocolate vs a banana, but the health benefits the banana may bring you vs the health implications that the chocolate may derive. So, according to this economic theory, we should all be making decisions that maximise our utility (net benefit) from our choices, so the next alternative (opportunity cost) is outweighed by the correct choice.
However, actual life isn’t like that! Billion-dollar industries are built upon selling you objects you don't need and encourage us to make impulse purchases that we often regret or do not fully utilise in the months or years after. We need to spend money to live, and there is a fine line between saving for the future and spending to enjoy today, but the focus of any efforts to apply opportunity cost to help you financially should really be focused on the more materialistic, impulse purchases. When purchasing, you need to consider the high amount of substitutes that may be more affordable and derive a near equal utility to the first choice.
To give an example, no one is refuting that we need to move around to travel to work or for general living needs. A car can be a sensible financial purchase in some cases, but there are many substitutes for buying the expensive new model that you currently desire. Other methods of travel are available, but if you do need to own a car, second-hand models or more budget makes can provide an alternative to the expensive flashy car you want to own. In the years after buying your car, the additional utility of a new model is likely to evaporate significantly, and therefore, the opportunity cost (what you could have done with the money left over, had you bought second hand) is likely to be larger than the figure you initially thought.
What is compound interest?
When we add opportunity cost to the science of compound interest (the second lesson I believe we should all be taught in school) the implications of opportunity cost can be significant. Compounding is the effect of interest earnt from the principal amount (your initial loan/investment) in addition to the interest accumulated over the years that you leave that money invested. By keeping your money invested over time, interest is earnt on the initial amount as well as any interest that you're accumulating over time, making the total investment greater and adding to the total pool of capital that will pay you further interest in the years to come. Albert Einstein reportedly stated:
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
This phenomenon means that when we calculate the opportunity cost of spending money, the alternative is to save or invest that money, rather than spend it on something else!
To give you a visual example as to how damaging spending money on unnecessary purchases can be, I have calculated compound returns for a nominal £1000 invested at the age of 18 over the lifetime of an individual from 18 to 65, with the premise that they remain invested and achieve an annual interest rate of 7% (7% is the long-term average return from investing in the global stock market). Each year as we get older, the number of years we have to compound our money becomes less, meaning our initial investment has less time to grow and accumulate. In essence, this means that the value of money to a young person should be more than the value of money to someone who is older. From this graph, you can see that £1000 invested at the age of 18 at a rate of 7% per annum (with 47 years till 65) will equal just under £25,000 when you come to the age of retirement. However, at the age of 40, with only 25 years to compound that same amount, your £1000 is worth only £5000 come 65 years of age.
I hope this helps to put some perspective around opportunity cost, and show that a big purchase in your formative years could have much greater financial implications than you would think. I also hope that the visual effect of compounding can dispel the myth that you need to have vast sums of money before starting to invest — as you can see from the chart, a large return can be derived from a long length of time invested in a productive asset.
Lastly, some snippets of advice when considering the opportunity cost and effect of compounding in day to day choices:
Buy things that derive real personal value.
Buy quality, low maintenance items that you won't have to replace as often.
Consider the future opportunity cost if you were to invest that sum.
Try to keep your money invested for the long term.
Purchase items that save you money or hold their value.
Cut small impulse buys (coffee, takeaways etc).
Consider the health implications of your purchases.