Munger's mental models #4: Opportunity cost

Mental models

In this short series of blogs and videos, in honour of the late Charles Munger, I take a look at some of his most powerful mental models.

Opportunity cost

Think about this Munger quote for a second:

"The real cost of any purchase isn't the actual dollar amount but the opportunity cost, what you could have done with that money if you invested it elsewhere."

With characteristic simplicity, Munger captures such an important facet of finance in this short quote.

Suppose you decide to take out a loan to buy a sports car for, say, $100,000...funded by your after-tax pay packet.

As you've already guessed, the cost of that purchase is going to be a whole lot more than $100k!

Sure, you get the use of the shiny new vehicle, but over the life of the loan the repayments might be $200k, and you may need to earn more like $400k pre-tax to pay for it all!

In a decade's time, you most likely have a car that's not worth a whole lot after all of the depreciation.

Obviously this is a stylised example, but when you contemplate what $200k invested over the course a decade might be worth - possibly double? - you can start to get a feel for the potential opportunity cost of the purchase.

One of the useful concepts I've learned over the past decade is to value experiences over things.

I explored the concept of the time value of money a little more here.

Opportunity cost in life

How about some other examples of opportunity cost?

Increasingly, young people have a tricky choice to make when it comes to pursuing higher education.

Back in my day, I graduated with a small student loan and the degree opened up many more avenues for a professional career (plus, crucially, I got to drink beer daily for three happy years) so the decision to go to Uni was a pretty straightforward for me.

Today, higher education can be much more expensive, so young people may need to think about the potential for higher income earning potential versus starting work earlier with no HECS debt.

In business, company owners often face the dilemma of whether to pay themselves a higher dividend or re-invest in their business for the future. 

The concept of opportunity costs implores to consider not only what we gain in life, but also what we potentially might lose - the unseen opportunities.

It's a key mental model for your career, personal finances, business, and life more broadly.

I discussed this a little further in the short video below:

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