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Example Alice deMoms realizes that she will need to replace her current car within two years or so. Anticipated changes in her lifestyle mean that she will need for roomier vehicle, capable of carrying more people and their belongings. So, Alice decides an SUV is the best bet. Alice likes to pay for her vehicles outright, instead of over time through a loan. Unfortunately, SUVs are more expensive than conventional cars. While she had only planned to spend $20,000 on her next car, she estimates that the SUV she's eyeing will cost $25,000 two years from now. In order to purchase her new car without a loan, Alice needs to evaluate her savings and investing plans in light of her financial goal. She has $60,000 in a secure low-interest savings account which pays 3.5 percent annually. Although this would cover the cost of the SUV, Alice feels uncomfortable liquidating more than one-third of her account for the new vehicle. So she decides to move some money into a higher interest bearing account to make up the shortfall in savings. Alice puts $20,000 into a mutual fund that ends up yielding 11.5 percent each of those two years: $20,000 x 11.5 percent (year 1) = $22,300 x 11.5 percent (year two) = $24,864.50. Had she left her $20,000 car purchase allowance in the savings account, she would only have $21,424.50 to spend on her new vehicle: $20,000 x 3.5 percent (year one) = $20,700 x 3.5 percent (year two) = $21,424.50. This means the opportunity cost in terms of annual interest rate was 8 percent (11.5 percent - 3.5 percent). In terms of dollars, Alice's opportunity cost for doing nothing would have been $3,440. Of course, opportunity cost is not the only factor to consider when saving money. The security of the investment and the risk of unguaranteed returns should be considered. For these reasons, Alice decides to keep the rest of her savings secure in the savings account. Although, for her next new car fund, she'll continue to put away money every month in the riskier, but potentially higher returning investment. After all, if the car fund doesn't perform as expected, she can always change her auto shopping goals. But if her savings were to disappear or underperform, this would be a much more troublesome outcome for her future. |