Have you ever tried explaining a concept like opportunity cost to a client that just doesn’t click? Chances are, the answer is yes. As financial professionals, it’s easy to fall into a routine because we understand the principles. For a client, however, this could be their FIRST introduction to a concept. So how do you demonstrate a concept in a way your client can understand?
Our last post discussed opportunity costs, and why the concept is crucial to your client's finances. The difficulty lies in the education of opportunity costs—it can be difficult to grasp whether you’re an advisor or a client. The typical argument against opportunity cost is that it deals with money that “doesn’t exist.” Due to that stigma, it is often left out of financial discussions.
What we’d like to instill, is that understanding opportunity cost is ESSENTIAL. So to help, we’d like to demonstrate a tangible way to show opportunity cost. Automobile Purchases is the perfect calculator for the job because it illustrates a common purchase, and it clearly shows the difference between a payment and a cost on one's savings.
To start off, input only the savings into the calculator. In this example, John Smith has a savings of $200,000, to which he adds $15,000 annually. To keep up with inflation, his savings increases by 4% each year. The ROR (rate of return) on this account is 7%.
Overall, you can see that John Smith is doing well. In 35 years, his savings account will have $5.7 million. This is indicated in both the upper right-hand corner or you can scroll down and see the total in the second column (BOY Asset Value NO Auto Costs).
Once the client can see the potential of John Smith's savings account, we’ll add in an automobile purchase. It’s crucial that your client understands the savings before moving on to this step—once all the numbers come into play, it can appear confusing.
So let’s say that John is a car fanatic, and every two years he finds himself with a new car. He spends $30,000 each time. Without even considering taxes or inflation, look at what has happened to John Smith’s account—that $5.7 has turned into $2 million. The cumulative cost of Mr. Smith’s cars over 35 years is only $1.1 million, so what happened to the other $2.6 million?
Seemingly, it has vanished into thin air.
While step two alone might be enough to drive the point home, we haven’t considered the effects of inflation and taxes. Nor have we factored in car insurance. To stay consistent with John Smith’s savings inflation, we’ll assume that the cost of his car inflates at the same 4%. That means that what was once a $30,000 car will cost much more than that 35 years down the road.
Let’s also assume that John pays taxes on his car at 6%. His annual insurance premium is $2,500, and due to inflation it also increases at 4%.
When you consider all of the additional car costs over 35 years, John Smith’s savings account is now down to only $1.2 million. That means that $4.5 million of possible savings has totally vanished. After all, the cumulative cost of Mr. Smith’s cars were only about $1.4 million.
Here’s what you must convey to your client: there is a difference between payment and cost.
While John Smith only PAID $1.4 million over 35 years, his cars COST him the opportunity to earn an additional $4.5 million. In other words, the interest rate would have had a greater compounding effect had he not touched his savings. Since he withdrew money on a regular basis, his account was unable to achieve its full growth potential.
So What Can John Smith Do?
While $1.2 million is great, there is a way for John Smith to enjoy the feeling of a new car and save even more money.
Instead of purchasing a new car every two years, what if Mr. Smith were to purchase a new car every four years? Over the same 35-year time frame, John Smith ends up with $3.1 million in his savings account. By reducing the frequency at which he purchases new cars, he more than doubles his savings.
Showing your client how this single change can positively impact their finances is a great way to end the demonstration. It’s important to end with a strategy!
By making this single change to his lifestyle, John Smith creates more opportunities for his cash to grow, which allows him greater control in the present and future.
Automobile Purchases is an excellent calculator to show opportunity costs because of this function that compares compound costs versus actual costs. It allows the client to see the correlation between payment and cost using a common purchase. Additionally, the Automobile Purchases calculator proves that opportunity cost is not money that “doesn't exist.” It's real potential that you can cost yourself by making frivolous purchases. Strategizing with these costs in mind requires that one look at their spending habits and identify what is truly worthwhile–it takes discipline, and it is the cornerstone to building wealth sustainably.