In this post, we’re going to give you a comprehensive framework to think about making financial decisions. Our framework is simple enough for anyone to use, yet powerful enough to handle every financial decision. Not coincidentally, findi is designed to leverage this framework, though the logic applies well beyond our product.
Let’s start by defining the problem: everyone needs to make financial decisions and most people don’t like to. There are two major barriers barring most of us from decision making. First, we don’t have the right tools to easily run the numbers. For example, in choosing to lease or buy a car most of us aren’t willing to build out a fully fledged financial model and can’t trust the dealership to point us toward an option in our best interest. Second, we’re vaguely aware that how we use money is a reflection of our values. When buying a car, we have to choose between getting something functional, family-friendly, or flashy, each of which will broadcast something different about ourselves to the world. At the surface, it’s not always clear how these two concepts relate and what the tradeoffs are, making financial decisions feel confusing and high-stakes.
Opportunity Cost as the Solution
We can solve the problem of financial decision making by thinking of personal finance as the intersection of opportunity cost and values. This may sound menacingly abstract, but I promise it will make sense in a minute. To make a decision using this framework, you simply calculate the opportunity cost of your decision and then decide if the financial impact is worth it to you based on your values. We’ll walk through the detailed examples below, starting by exploring opportunity cost.
Simply put, opportunity cost is the price of not making a different decision. Let’s take attending college as an example. College comes with a host of actual costs in the form of tuition, boarding, books, etc. If you didn’t attend college, you could do something else with this money. In addition to these actual costs, there is the opportunity cost of passing up full-time employment to attend. If you believe you could have made $20K a year working full-time with a high school degree, there would be an additional $80K opportunity cost in wages you passed up during 4 years of attendance. Thus, when we accurately account for all costs, the opportunity cost of college attendance is all the fees you pay plus this $80K of wages missed by making the decision to attend.
So how do we compute opportunity cost? The simplest way is to model each choice you could make, calculate your net worth after choosing each option and take the difference. However, in practice it can be quite challenging and time consuming to build in all the correct assumptions and make sure the math is right. At findi, we build the model for you, make the assumptions clear, and calculate the tradeoffs between decisions so you can focus on making moves that will improve your life, not crunching numbers.
As a side note for finance nerds (and skippable paragraph for others), another way to solve the complexity of scenario modeling is to assume your other option is always to invest money with some fixed rate of return. This approach leads to the discounted cash flow (DCF) model used by companies to make investment decisions. While DCFs provide a standard way to make business decisions and value investments, this approach is less precise because it fails to model out the changes in cash flows and rates of return for the base scenario. Additionally, while large companies may reasonably assume they have a nearly limitless number of revenue-creating projects they can launch (and thus set a bar for what is “good enough”), this assumption makes less sense for individuals.
The Role of Values
Returning to our college attendance example, few people would make the decision to attend on the basis of opportunity cost alone (and if we did, we’d also need to model out student loans, future earnings, etc.). While the notion of higher earnings certainly factors in, for many people the intrinsic value of education, the connections gained, and the more fulfilling careers are just as important. Humans are not simply cash flow optimizing automatons, and so it’s also important to consider the role of values in personal finance.
As uncomfortable as it may be to acknowledge, how we spend our money is at least partly a reflection of our values. This is not to say you can simply bucket your spending and rank order the most important value categories, but rather that we generally spend our money on things that are important to us. It’s no coincidence that housing is often the biggest expense in our lives; shelter is highly valued by most people. This way of thinking can lead to some uncomfortable truths. For example, add up your charitable giving and compare it to, say your expenses eating out over the same period, and you may find your spending doesn’t always reflect an image of generosity.
The goal of personal finance is to align your financial decisions with your values. You shouldn’t simply choose the mathematically optimal solution, but you should understand the opportunity costs and tradeoffs associated with your decisions. The problem with personal finance arises when costs and values are misaligned. For example, if you want to retire early, but carry a high-interest credit card balance your finances and values are likely misaligned. If you really care about retiring early, your income should be going toward some sort of nest egg, not toward providing a comfortable retirement for employees of Visa or Mastercard. Then again, maybe you really do value the immediate gratification carrying a credit card balance allows more than your retirement prospects. Carrying a balance isn’t inherently wrong, but you should be aware of where your money goes and how that matches up to what’s important to you.
Real World Example: Paying Off Student Loans
I’ll end by working through this framework for a real world example. While I hope this example is instructive, I’ll be simplifying the math and the numbers will obviously be different for you. Findi is designed to solve both these problems, by giving you the tools to easily customize the logic to your unique circumstances and taking care of the modeling complexity (though you can peek under the hood if you’re curious) so you can focus on the outcomes.
When I graduated college, I had roughly $50,000 in student loans. I quickly refinanced and consolidated my loans (one of the few no-brainer financial decisions you can make, but that’s a subject for another post) to something around a 3% interest rate. When I started my first job, I chose to pay off my loans as slowly as possible, assuming that I’d get more like a 7% return by putting my money into an investment account (a tax-advantaged Roth IRA and a subject for another post). In my case, for every extra dollar I put in the Roth I earned $0.04 more than by putting that same dollar towards my loans. In the language of opportunity cost, I would say that there was a $0.04 opportunity cost for each dollar (in excess of the minimum monthly payments) used to pay off my loans. Because I valued having a long-term savings cushion more than being free of my loans, my financial decisions were aligned with my values.
Eventually, I reached the point where I had about $5000 left in loans. Like many people, I was eager to be free of debt and monthly payments. The cognitive (or for some people, moral) burden of outstanding debt may not be entirely rational, but rational or not, it can have a real impact on our lives. Running through the math, I realized I had two choices:
- Continue to make the minimum monthly payments and invest the excess in my Roth. The $5000 I’d invest would earn 7%, and I’d be $350 richer at the end of the year. However, because I’d still have loans I’d be accruing 3% interest, or roughly $150 for the year (an oversimplification because the principal goes down with each monthly payment, but good enough for this example). At the end of the year, I’d have paid off my loan and, after accounting for the earnings from my investment and subtracting off the additional loan interest, I’d be $350 – $150 = $200 up in this scenario.
- Pay off the remaining balance now. In this case I wouldn’t accrue any interest at the 4% rate, but I also wouldn’t have that $5000 to invest, so I’d be passing up the potential for 7% returns. Like in the other scenario, I’d have paid off the loan by the end of the year, but I wouldn’t have the extra $200.
Framing this in terms of opportunity cost, paying off my loan in entirety at the start of the year would incur a $200 opportunity cost. So what did I choose? I chose to pay off my remaining balance and be done with student loans once and for all. This wasn’t mathematically optimal, but for me eliminating the cognitive burden of debt was worth $200.
Have questions, comments, or suggestions for future posts? Leave me a note below and I’ll do my best to reply.