Why Investors Should Focus on Opportunity and Crossover Cost

Why Investors Should Focus More on Opportunity & Crossover Costs

Share on facebook
Facebook
Share on google
Google+
Share on twitter
Twitter
Share on linkedin
LinkedIn
Share on pinterest
Pinterest
Share on reddit
Reddit
Share on whatsapp
WhatsApp

The FIRE (Financial Independence, Retire Early) crowd has tapped into a fundamental truth that most folks miss in our consumer-driven world—namely, the pursuit of financial independence is like a double-sided coin. Yes, half the equation is investing; however, we can’t ignore the other side of the coin—spending. In this article, we’ll explore why investors should increase their focus on the dreaded opportunity and crossover costs when it comes to achieving their long-term financial goals!

I encounter folks all the time that tell me how much they want to start investing—and possibly achieve financial independence early. However, they then digress into a predictable soliloquy about how they just don’t have the cash to do it. Yet, almost inevitably, I see these same folks sipping their favorite Starbucks concoction every morning—and sometimes several times a day!

I don’t normally write about personal finance matters—passive-income investing is my specialty. However, I think this subject is actually closely connected to achieving long-run investing success… and, clearly, folks seem to need a refresher on crossover and opportunity costs!

We’ll use the ever-popular cup of coffee for illustration purposes… but you can and should do this with whatever unnecessary—but seemingly immaterial—habits you may embrace in your life.

So, what’s the real cost of that heavenly cup of java?

Financial independence is not easy to achieve. It requires some degree of sacrifice. I’m not saying you have to live in a cardboard box and eat ramen noodles. However, managing our expenses is critical to investing and achieving our financial goals—and they can quickly add up to BIG costs… much bigger than we may want to believe!

Let’s take a look at the real cost of that cup of Joe…

Table of Contents

Is Spending Really That Important When It Comes to Financial Independence?

As I eluded to in the into, financial independence is akin to a double-sided coin. On one side of that coin, you have investing. On the other, you have spending.

Most like to focus on the investing side of the equation. However, there is an inescapable relationship between the two. Obviously, the more you spend—the less you can invest. The more you invest—the more you can spend down the road.

I find that the aerodynamics of an airplane are a great illustration of the financial forces we must overcome in order to achieve long-run financial success.

You have four forces at play: lift (passive-income), thrust (investing), weight (your essential living expenses), and drag (your non-essential spending).

Financial Aerodynamics

Like a plane, when you generate enough financial lift (passive income) to overcome your financial weight (essential expenses), then you break your bond with the ground (job) and take flight—you achieve financial independence. You can go soar with the birds and pursue whatever activities you chose.

Now, to generate that precious lift, we need thrust. Our financial thrust is called investing. The more thrust we provide, the more passive income (lift) we achieve.

However, like with that old puddle jumper, there is a dastardly force that counters our financial thrust—drag (or non-essential spending). The more we spend, the less we can invest! And, the less we invest, the less lift we produce… and the less lift, (you guessed it) the less weight we can handle and still get off the ground.

Thus, you cannot achieve ultimate financial success if you neglect to deal with your drag—or discretionary spending! It will rob you of your lift. And if it robs enough, you won’t get to a point where your lift (passive income) will overcome your essential living expenses! You won’t fly—meaning, no financial freedom and no retirement (at least without having to work part time).

So, how important is managing our non-essential spending? Extremely important!

Investing Success Requires Understanding the Impact of Secondary Consequences

So, we need to manage (and minimize if possible) our financial drag—or non-essential spending.

However, this requires assigning accurate costs to our spending decisions… and that’s where a lot of folks run into problems and fall short!

When determining the true (full) cost of our spending decisions, we must look beyond the highly-visible (and obvious) primary consequences. We must seek to identify and quantify the less visible (but no less important) secondary consequences.

As economist Henry Hazlitt so aptly noted, “The persistent tendency of men [is] to see only the immediate effects of a given [decision]… and to neglect to inquire what the long-run effects of that [decision] will be.”

He adds, “From this aspect, therefore, the whole of economics can be reduced to a single lesson, and that lesson can be reduced to single sentence. The art of economics consists of looking not merely at the immediate but at the longer effects of any act or policy.”

The failure to identify long-run effects of spending decisions has resulted in more failure to achieve long-term financial goals than any other deficiency. It robs us of thrust—and, therefore, financial lift!

Side note: You can think of your portfolio yield as correlating to the shape of your wing. The higher the yield, the more lift it will produce—reducing the amount of thrust required. I explore this factor in more detail in my article What Joule’s Law Can Teach Us About Investing for Retirement—using a different analogy (electrical power).

Now, for passive-income investors (and especially those seeking FIRE), there are two ways of approaching expenses to identify those hidden secondary costs: looking backward and looking forward.

When we look backward, we are addressing what’s known as “crossover” costs. On the flip side, when we look forward, we are identifying opportunity costs.

Both are important to consider—just different perspectives.

In general, the closer you get to pulling the ripcord on your parachute and retiring, the more you want to look backwards and focus on your crossover cost. Likewise, the younger you are and the more investing runway you have at your discretion, the more you want to focus on looking forward with opportunity cost. However, both are useful points of comparison—no matter what stage of the financial independence journey you’re at.

Let’s see what that looks like for our cup of coffee…

Identifying Crossover Costs for the Passive-Income Investor

The fundamental reason for passive-income investing is to reach a point at which that passive-income exceeds one’s cost of living. At that point, you have officially achieved financial freedom!

You could walk away from all your active sources of income and nothing in your life would have to change. That doesn’t mean you have to walk away. Rather, it simply means you have the freedom to do it if you so choose.

That point is referred to as your “crossover” point in FIRE circles, as well as in infinity investing. Again, it occurs when your passive-income equals your expenses. This is where you have enough lift to takeoff and fly like a bird!

With this goal in mind, we can evaluate the true cost of your coffee drinking habit. By looking backward, we can calculate how much money we would need in our investing account to cover that expense.

Let’s say that cup of coffee costs you $4.50—though it is easy to exceed that at Starbucks.

If your portfolio has a target yield of 5%, you would need $90 to cover that expense!

That means, from a retirement perspective, you just burned $90 of portfolio value—or buying power! That’s a pretty darn expensive cup of coffee!

And, if you purchase one cup of java a day from your favorite barista, you would need $32,760 to support that habit with passive-income!

Stated differently, you would have to allocate $32,760 of your retirement portfolio to exclusively paying for your coffee consumption each year via your passive-income dividends!

But, that’s just one way of looking at the cost. Let’s explore what the opportunity cost is when looking forward…

Identifying Opportunity Cost for Long-Term Investors

Opportunity cost represents the benefit, profit or value of something that must be given up acquiring or achieve something else.

The economic concept is predicated on the scarcity of resources. You and I don’t have unlimited wealth. Therefore, we must choose where to allocate our money. Whatever we choose to allocate our cash to necessarily means we are choosing not to allocate it to other things.

A dollar spent on coffee is a dollar we can’t invest in our portfolio.

If any of those other options would have provided us with greater value, then there was an opportunity cost for our choice.

There are two components to determining opportunity cost: explicit cost and implicit cost.

Explicit cost simply represents the cost actually paid (i.e., the cash expenditure). As such, it represents a lost opportunity to purchase something else with that cash. In terms of our cup of coffee, the explicit cost is the $4.50 purchase price.

This is the cost most folks identify when they buy things—it’s obvious. I spent $4.50 on coffee, so that’s $4.50 less I have to spend on other things (I can’t spend it twice!).

However, explicit costs only represent the primary (and highly visible) consequence of our decision. As such, they only represent half the story!

Implicit cost (also referred to as imputed or notional) represents those less-visible secondary consequences of our decision. In other words, it represents additional costs inherent in our decision not to allocate our resources (the explicit cost) to an alternative use—hidden secondary costs that most folks blindly (and often blissfully) ignore!

Specifically, for long-term investors, the implicit cost represents the lost opportunity to generate income with those resources.

By looking forward, we can calculate the future value of that explicit cost—and, therefore, the implicit cost.

For that cup of coffee, if we had invested the $4.50 for 30 years at a conservative 5% annual growth rate, we would have generated $14.95 in gains.

Thus, the total opportunity cost for that cup of coffee is $19.45!

Opportunity Cost for a Cup of Coffee

Again, that’s an expensive cup of coffee!

But that’s just one cup of coffee. What about—God forbid—a full-fledged coffee habit?

Let’s assume we buy one incredible grande iced caramel macchiato a day. Right now, in my neighborhood, that’s $4.45 a pop—but we’ll just round back to our $4.50 base cost.

What’s our long-term opportunity cost? We can use the future value equation to easily figure that out.

Let’s assume, instead of buying those coffees, we take that cash and invest it in our dividend-growth portfolio on a quarterly basis over 30 years (at the same 5% annual rate of return).

Our opportunity cost would be a mind-blowing $112,701.39!!!

Furthermore, as you can see above, that lost opportunity would have provided us with $6,762 in annual passive-income!

Building on our example, we invested our “coffee” money for 30 years—taking us from say 30 to age 60. Now, we pull the trigger and retire. Let’s say we live to 85, or 25 years in retirement. That’s an additional opportunity cost of $169,052—25 years’ worth of $6,762 in annual passive income!

(Again, this is income we wouldn’t have if we bought that daily cup of coffee)

When we add that all together, we find that our true opportunity cost for drinking one cup of coffee a day for 30 years is $281,753!!!

(And this doesn’t even factor in dividend growth—but we’ll just say that offsets inflation for simplicity sake)

Now, I’m not saying don’t drink coffee lol. I’m just saying (a) you need to understand the crossover and opportunity costs for your spending decisions and (b) seek opportunities to reduce those costs—such as making your own coffee at home the old-fashioned way!

That’s a lot of capital you could allocate to your investment account and retirement goals—whether they’re traditional in nature or more along the lines of pure high-octane FIRE!

And, if you purchase that coffee on a credit card (and don’t pay it off by the end of the grace period), your opportunity cost increases even more… a whole lot more!

(You would have to consider the future value of every interest payment on that coffee!)

To borrow from our earlier plane analogy, interest paid is like ice accumulating on your wings—it’s an invisible killer that will rob you of even more financial lift!

The point is so simple an idiot could grasp it… but oh so hard for even the brightest bulb amongst us to accept when that “coffee” is calling your name. Everything has a costboth a visible and a hidden one.

Be smart, be informed (know the real costs), and choose wisely my friends!

Conclusion

I hear people say all the time that they just don’t have a lot of money (i.e., free cash flow) to invest towards their retirement or other financial goals. They say this at the same time they are frequenting Starbucks on a daily basis!

(or spending $10-15 on fast food every day… or ordering $25-35 worth of Papa John’s a week… you pick your own poison!)

When you ask them about their spending decision, you frequently hear, “Hey, I work hard and make good money… I deserve to buy my daily java!”

While I can’t speak to whether or not they “deserve” that coffee, I can say that I find most don’t understand the real cost of their spending decisions!

They typically fail to consider or fully grasp the secondary—less visible—consequences (costs) of their decisions.

There are two ways to quantify the real costs from an investing point of view:

  • Crossover Cost (Looking Backward)
  • Opportunity Cost (Looking Forward)

As we’ve seen, the real cost of that coffee habit is pretty darn high!

From a crossover perspective, you would need a conservative $32,760 in your portfolio to cover that habit with passive-income! (That’s $32,760 just to buy your coffee each year—forget about all your other expenses!)

More importantly (in my humble opinion) is the opportunity cost. From an opportunity cost perspective, the real cost of that cup of steaming-hot (or iced) Joe is $19.45—pricey even by Starbucks standards!

For our example, if you include your retirement years, that real cost soars to $43.76!!!

Furthermore, the total opportunity cost for purchasing a $4.50 cup of coffee a day over a thirty-year period (say from 30 to 60) is a mind-numbing $112,701!!! That opportunity lost would have provided you with $6,762 in annual passive income (dividends)… for the rest of your life!

Again, if you include that passive income received during your retirement years (and you should), your total opportunity cost climbs to an astonishing $281,753 based on the parameters we used!!!

Crossover and Opportunity Cost for Coffee

Again, I’m not suggesting you sell your worldly possessions and go live in van under a bridge!

Nor am I saying coffee is the devil and the only expense you need to look at! (full disclosure, I love my coffee too)

I’m merely suggesting that you begin to view your expenses—especially those seemingly little and innocent ones—through the lens of crossover and opportunity costs. Is the expense worth what you’re really sacrificing?

Doing so may just revolutionize your approach to investing, retirement planning, and life!

One final note: I personally find that the best way to increase your investing capability is to reduce your expenses—as opposed to seeking higher income. There’s nothing wrong with adding income; however, the danger is that you end up simply increasing your spending to match your new income—digging your hole deeper rather than climbing out quicker! Best case is a combination of both—but, if you had to pick one, I’d work on that spending.

Furthermore, I would be very cautious with adding side hustles. If you can’t control your spending, you’ll just end up needing to add a second one, and then a third one! They can be a force for good (a beneficial financial force multiplier), but I’ve seen folks end up working 90+ hours a week juggling “hustles” while still getting nowhere on their investing or towards financial freedom!

As Buffett would say… It’s not about how much you make—it’s about how much you keep! (While he was referring to the market, his advice applies equally well to our personal finances)

Work on getting yourself to a place where you can always pay yourself first… and increasingly more!

M1 Finance | Automatically Invest in What You Want for Free

If you’re interested in dividend-growth investing predicated on a value framework—you’re in the right place! We focus exclusively on helping others be as successful as possible with this income-based approach to investing and we hope you’ll continue to return to our site to learn, grow, sharpen your skills, and find effective and positive ideas and motivation!

Soak it all in, take and use what you want, modify it to fit your unique situation, and keep building that portfolio with a solid process and winning mindset!

We also encourage you to follow along with our public Wicked Capital Passive-Income Portfolio (PIP) through our monthly updates on the website and by viewing the portfolio on M1 Finance at https://m1.finance/1zUclN2JL

It’s a great way to learn from a real-world example of building and managing a dividend-growth portfolio predicated on a value investing framework!

Finally, if you’re interested in starting your own portfolio using the M1 Finance platform (which we highly recommend), please consider using our referral link https://mbsy.co/sZVS3 and we’ll both get some free cash!

That’s just one more reason to start your dividend-growth investing today! It’s never too soon to start working towards your financial freedom!

Credit:
Plane image by thejakesmith from Pixabay

Doug

Doug is the founder of Wicked Capital. He holds an MBA, BBA (Summa Cum Laude), and AAcc from Liberty University and has over 20-years of corporate finance, accounting, and operations management experience--spanning the public, private and nonprofit sectors. He is a member of Sigma Beta Delta International Honor Society in Business Management and Administration, Delta Mu Delta International Honor Society in Business, and Tau Sigma Academic Honor Society. He is also proud to have served his country as a member of the 82nd Airborne Division. His professional wheelhouse is corporate financial reporting, analysis, and forecasting—buoyed by his passion for fundamental analysis and valuation. Doug has been actively engaged in trading and investing for several decades, with a focus on value and dividend-growth investing. He has authored several books and, when he's not busy living the corporate dream, trading and managing investment portfolios, he enjoys playing the drums and spending time with family--especially in the Outer Banks of NC.

More GREAT Educational Articles

Click HERE to view a current listing of all our portfolio updates!

RECENTLY PUBLISHED WICKED CAPITAL ARTICLES

Always remember, investing involves substantial risk of loss and is not suitable for everyone. The valuation of investments may fluctuate, and, as a result, you may lose substantial amounts of money. No one should make any investment decision without first consulting his or her own financial adviser and conducting his or her own research and due diligence.

You should not treat any opinion expressed on the Wicked Capital website as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of opinion for entertainment purposes.

The opinions are based upon information we consider reliable, but neither Wicked Capital nor its affiliates, partners and/or subsidiaries warrant its completeness or accuracy, and it should not be relied upon as such.

Past performance is not indicative of future results. Wicked Capital does not guarantee any specific outcome or profit. You should be aware of the real risk of loss in following any strategy or investment discussed on this website.

As noted above, strategies or investments discussed may fluctuate in price or value. Investors may get back less than invested.

Investments or strategies mentioned on this website may not be suitable for you. The material presented does not take into account your particular investment objectives, risk tolerance, financial situation, or needs and is not intended as recommendations appropriate for you. You must always make an independent decision regarding investments or strategies mentioned on this website. Before acting on information provided on this website, you should consider whether it is suitable for your particular circumstances and strongly consider seeking advice from your own licensed financial or investment adviser.

Copyright © 2019 Wicked Capital. All Rights Reserved