“Save 100% When You Don’t Buy Anything”: Opportunity Costs and Compounding Interest
“Save 100% When You Don’t Buy Anything”.
A social media photo showed this sign outside the entrance to a store- pretty funny, I thought.
It brings up a valuable point.
We make decisions about buying (or not buying) products and services all the time. In some cases, I don’t give much thought. But if you look at the impact over a year- or 10 years- the impact may be significant.
My Long-Term Bad Habit
I go to Panera six days a week and buy a $6 drink. It’s 400 calories, it’s not good for me- and I convince myself that I deserve it after going to the gym.
A good rationalization, right?
OK, six days times 50 weeks a year (I’ll subtract vacations) is 300 purchases. At $6 a visit, I’m spending $1,800 a year.
What else could I do with $1,800 annually?
Understanding Opportunity Costs
Opportunity costs is defined as what you give up by choosing A rather than B.
We deal with opportunity costs all the time because we make decisions all the time.
What make and model of car should I buy?
Should I apply to graduate school? If I get in, do I quit my job and go full time?
What career should I pursue?
I’ve convinced myself that spending $1,800 a year at Panera is worth it- the choice gives me more value than other alternatives.
But- just for kicks- what if I invested the money in the stock market?
Defining a “Normal” Return on Stocks
So, what’s a “normal return” on stocks, if such a number exists? Seeking Alpha (a site I highly recommend) has some great stats on historical returns for the S&P 500 from 1928 to 2015:
Over 88 years, the S&P 500 went up 64 years and went down 24 years.
The worst return was -43.84% in 1931 (ouch), and the best return was 52.56% in 1954.
The mean return (think average) was 11.4122%
So, what’s normal? Seeking Alpha says 11%, and other stats suggest 8-10% over a 70-80 year period.
Let’s use 10% and assume that I invest the $1,800 for five years. How much could I earn if I reinvest the annual earnings?
The Magic of Compounding
Compounding interest is defined as earning “interest on interest”, and when you compound interest, your total earnings can be much higher.
To explain, assume that you purchase a $1,000 5% bond.
In year one, you earn $50 ($1,000 X 5%). Here’s the key point: in year two, the investor keeps the original $1,000 invested, plus the year one earnings of $50. The total amount invested in year two is $1,050.
$1,050 invested in 5% = $52.50 in interest. By investing an extra 50 bucks, you earn $52.50- or $2.50 more than in year one.
Now let’s apply it to the $1,800 invested, assuming a 10% annual return for five years. With stocks earnings are generated from both dividends and price appreciation on the stock. So, we compound earnings- not interest- with stocks.
To compute the amount, I use a future value table. I use the figure for 10% (across the top of the chart) and 5 years (down the left-hand column). The future value factor is 1.61.
So, my $1,800 is worth ($1,800 X 1.61), or $2,898. I earn $1,098 over five years.
Not bad…
Other Financial Decisions
You can use this strategy for a number of different decisions. For example, my oldest daughter debated between selling stock to buy a condo, or keeping the dollars invested and continuing to rent. (She bought the condo).
There are always other factors to consider, but calculating the potential return on investing money is a valuable tool.
Food for thought.