I recently spoke at my son’s school for career day representing financial advisors. The other guy presenting is an airline pilot. I was sweating how engaged the kids would be during my talk. If I was 6th to 8th grade I would’ve gravitated toward the pilot! I shared a little bit of my story and how I got into this line of work and what it takes. My goal was to give the kids a takeaway about how to make smarter financial decisions. In my opinion the thing we all need to do, hopefully what all advisors are out there doing, is focus on opportunity cost.
Opportunity cost is the price paid to get more of something in the future in exchange for immediate gratification. It’s fundamental to economics. One of my deals was I’d either give the kids a candy bar today or two next week. Most took the two next week. The one who wanted the candy bar today said he was hungry. So, the opportunity cost for delaying one candy bar for two varies depending on how hungry a kid is. The second example I used was the old penny proposition: I’ll give you $1,000,000 today and guarantee a 10% rate of return for the rest of your life, OR I’ll give you a penny today and double it each year and offer the same guaranteed 10% return assuming it stays invested. Now we’ve added an interest rate and need to look at present and future values. Right off the cuff, which would you choose? Is the $1,000,000 now a no-brainer? Of the 20 or so kids, only two picked my penny proposition. After 10 years the kids with the pennies have accumulated about $12. The other group has nearly $2.6 Million. What about after 20, 30 or 40 years? Long story short, at 30 years the penny takers come out slightly ahead. Starting at year 31 the penny takers vastly outperform the original million bucks I offered, remember the amount doubles each year. I’m 50; the kids in the classroom were between 12-14. They are likely to live long enough to get the payoff of the penny. Not me, I’m taking the million. I’ll likely live another 30 years, but I’ll be 80 by then. I’ll be too old to enjoy that extra money the penny proposition promises. The opportunity cost to wait isn’t there.
Another area where this is applicable is the lottery: take the lump sum or have it spread over 20 years? Similar dilemma. You can invest the lump sum up front and start it compounding. Or you can take it over the years and potentially pay less taxes on it if it’s a smaller amount. Let’s say the value of your lottery winning is $1 Million. Your options are to take it all at once and pay 40% in federal tax. OR take $50k per year for 20 years at a 20% federal tax rate. Which is better? The higher the interest rate you assume your money will grow, the better the lump sum is. Also in order for the stream of payments to be advantageous you need to assume an unrealistically low tax rate.
Obviously nobody is doubling our pennies every year and winning the lottery is a real longshot. But we face the same dilemma on a regular basis. Do you buy a car now for cash or wait until you saved enough money? What’s the opportunity cost of not having a car? Can you take a cab or a bus to get by or do you absolutely need that car? What are you giving up purchasing that car? Did you sell NVDA stock before it skyrocketed? What about financing a car vs. paying cash? This dilemma is similar if not exactly the same as our penny proposition. How much are you willing to sacrifice now for that immediate gratification? Do you rent vs. buy, lease vs. own, save for retirement or use a taxable account…? Do you pull out a large lumpsum that’s taxable at a higher rate, or get a loan and withdraw over time? All of these involve an opportunity cost.
Another real-life example where this is applicable is divorce. Good divorce attorneys understand present and future values of income streams. I’ve seen so many divorces where the math isn’t considered, and one spouse gets jilted while the other comes out way ahead. People sacrifice a guaranteed rate of return for a risky investment that is seemingly more valuable on a regular basis. Clients have showed me how assets are to be split and I’ve said, “You need to sign this and hope it goes through as quickly as possible because you will not find a better deal.” I’ve also told people not to take a certain deal and go back to the attorney and ask for more. Knowing how to look at this, I’m happy to provide my professional services to either side!
Any of these decisions, from loans to lottery revolve around opportunity cost and the present and future values of money. A good advisor can sift through this with you. Not taking the math into consideration can have life altering consequences. Career day was fun though. I think the kids liked the pilot better, but I know I got them thinking. I lied though earlier; I definitely would have gone to the financial advisor at career day. Around age 14 I saw "Wall Street" with Michael Douglas and Charlie Sheen and SO wanted to be those guys. Coincidentally the premise of the move was Michael Douglas screwing over an airline.
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