The issue: opportunity cost

You help clients invest what’s left after they’ve spent their money. But what if you could help them better understand their spending and maximize those leftovers?

Most people don’t think about spending in a rational way. Thinking about money and how to spend it is difficult, and thinking about its value in the future is almost impossible. That’s because it is hard for us to consider the opportunity costs of objects we purchase.

In other words, people rarely say, “If I buy this cup of coffee today, I won’t be able to purchase X [e.g., 5% of a book] tomorrow.”

What’s the trade-off?

I conducted a study with people on the verge of purchasing a car to determine their ability to assess the opportunity cost of that purchase. We asked: “If you buy this Toyota today, what will you not be able to do in future as a result?” More than 90% of respondents couldn’t answer the question.

After some probing, the majority said, “If I buy this Toyota today, I will not be able to buy a Honda tomorrow.” Nobody said, “I will not be able to buy 300 lunches at a restaurant,” or “I will have to give up seven family vacations.” They were making real trade-offs, but the participants couldn’t compare the value of money across categories or time.

Part of what makes money so complex is we can use it to buy so many different things. If someone gave you some coins and said, “You can only buy clothing with this,” it would be easy to determine how much utility you could get with the coins. But, absent that specific directive, it’s more difficult to figure out how to use our money.

Can’t touch this

The opaque nature of modern spending makes things even harder by making money less tangible. If I gave you $1,000 in an envelope each week, you would see that what you’re spending comes at the expense of other things you may purchase. But with credit and debit cards, loans and mortgages, financial mechanisms have become increasingly muddied, making it more difficult for people to compare the value of spending now with the value of money in the future.

What advisors can do

Help clients better understand their spending habits and encourage them to think about the opportunity costs of everyday purchases in relation to their investments. In the long run, saving more may have a much greater impact on their financial security than rates of return.

The best way to do this is to garner a better understanding of the irrationality behind spending decisions, and to regularly assess your clients’ spending habits. Explain the 30 coffees clients buy this month may be equivalent to $1,000 per year in retirement income. Or if someone wants to take a $2,000 trip to Iceland, explain each $40 dinner out is 2% of that vacation.

And encourage clients to consult you on big spending decisions. If they’re setting out to buy a large house in the suburbs, talk to them about all the costs associated with that—commuting, higher utilities, maintenance and renovations, new furniture—and ask them what they’re willing to give up now and in future in order to make that stretch.

A lot of people feel entitled to have it all. Most can’t. And it’s your job to make that clear.

Irrational valuations

Irrelevant influences and considerations, such as a person’s present emotions or anchor values, can influence how much worth someone places in an object (see advisor.ca/anchoring).

In a study, Professor Dan Ariely and his team asked participants to determine the value of objects like wine, chocolates and electronics.

“We first told them to consider whether they would pay the amount equivalent to the last two digits of their social security numbers,” he says. “We found a significant correlation between the amount they were willing to pay and these digits.”

For instance, someone whose SSN ends in 25 valued the objects much lower than someone with the last two digits of 78.

For no logical reason, the test subjects gravitated toward the most recent number they had considered in order to value the items. Even with full information about the objects, most people had no logical point of reference to help them place a value on these objects, instead using their own (irrelevant) past decisions or experiences as anchors.