Before buying anything, always calculate the opportunity cost when making a major investment. If you do, you will spend less and build wealth faster.
I love window shopping and never buying a gosh darn thing. Vendors hate me, but my bank account thinks otherwise.
This habit started when I was a teenager making minimum wage with shoes and clothes. Spending 30 hours slaving away behind a grill to be able to buy a pair of new basketball shoes felt like a bad trade. But at least working those laborious jobs made me appreciate the value of a dollar.
Then, when I had a regular day job, my window shopping habit morphed into visiting car dealerships and test driving the latest models. There were several dealerships on the drive home so I figured why not drop by, eat a free cookie and have a free beverage while inhaling that lovely new car smell! I must have averaged 20 visits a year for 10 years. It was impossible to buy a new car when I knew the money could be invested to make more money in order to finally escape work.
Now I'm addicted to putting in lowball offers on homes and going through rigorous negotiations. If I win, money will likely be made. If I lose, awesome, because maintaining a property and paying never-ending property taxes are no fun. Since 2H2017 I've submitted four lowball offers with likely more to come.
It feels amazing to walk to the edge, look down, and walk back to safety. Do you guys ever feel the rush of this type of excitement, that is, almost parting with your hard-earned money?
Calculate Opportunity Cost: A Slightly Better Counter Offer
In a previous post about big homes and egos, I mentioned that I had put in a $1.95M cash offer for a larger house asking $2.2M. They verbally came back and said they wanted $2.3M, which I found absurd so I didn't bother to respond with anything in writing. Since then, a couple weeks have passed and they are now offering another counter, this time at their original asking price of $2.2M.
It was nice that they came down by $100,000, but the price was still not enticing enough given the amount of work that would be involved to update the home. I considered countering in writing with an offer of $1.98M, but then wrote them this letter instead.
The letter's original intent was to convince them to sell to me below $2M, but instead it ended up convincing me to not pursue the deal any further!
The Real Estate Love Letter
Dear Seller,
Thanks for the counteroffer, but we cannot afford this price. We went back a couple times to check out the foundation with a couple professionals, and there is foundation work that needs to be done to level the house and retrofit the house in case of an earthquake.
The city has already made it mandatory for wood frame multi-unit apartment buildings with garages to be retrofitted to the tune of $100,000 – $300,000. We believe it’s only a matter of time before the city identifies pre-1970 wooden frame multi-story houses over a garage which will also require retrofitting. With addition to the remodeling work planned, we simply do not have enough funds left to comfortably afford your home.
The real estate market is also at an all-time high, but it is slowing as interest rates are rising, rents are flatlining, and the stock market is stuck down 10% for the year. The stock market is foreshadowing a slowdown in corporate profits and job growth. With the institution of the mortgage interest deduction and state and local income tax cap this year, it’s an inevitability real estate prices will slow.
We need room in our budget to account for unforeseen expenses that come with remodeling an old house and dealing with new city retrofitting rules. At $2.2M, it would make much more sense to simply buy a completely brand new home on the market for $2.7M and save all the hassle and time.
Finally, the alternative to buying the house is to simply reinvest the money in risk-free 10-year treasury bonds yielding 3%. With a $2M investment, we would earn $60,000 a year, or $5,000 a month guaranteed without having to do any work or have any worry. A simpler life sounds pretty good to us as we take care of our baby boy.
If you would like to reconsider our offer sometime in the future, let us know. Our lines of communication are always open.
Regards,
Sam
Counter Letter Analysis
The key paragraph that convinced me not to buy this house was the one on investing $2M in a 3% yielding treasury bond. Earning $5,000 a month, free of state income tax, is a lot of money for us. It's enough to pay for all our existing housing costs and some weekly sushi dinners.
Not only would spending $2M on this house have an opportunity cost of $60,000 a year, it would also have an ongoing carrying cost of $25,000 in property taxes.
Therefore, the actual cost of owning this home without accounting for any of the remodeling and ongoing maintenance costs is $60,000 + $25,000 = $85,000 / year.
When I recognized the true cost of owning this home, it became very clear to me that even with its much lower price/sqft asking price, the house wasn't a steal.
At a $2M purchase price, I estimated it would cost another $350,000 – $500,000 to fix the house up. Add on $85,000 in opportunity cost and now we're talking an all-in cost of $2,435,000 – $2,585,000. Add on another $130,000 in taxes and commissions to sell the house, there simply isn't enough profit for the risk.
Run Through Various Opportunity Cost Scenarios
Whether you are buying a vacation property or investing your entire bonus in Netflix stock, it's always important to calculate the opportunity cost of not investing elsewhere.
To calculate opportunity cost, know what the baseline opportunity cost is.
The baseline opportunity cost is always the risk-free rate of return, also known as a US treasury bond. I use the 10-year treasury bond yield as a barometer.
The US government isn’t going to default on their debt obligation and you will get 100% of your principal back and the annual coupon if you hold until maturity. If you decide to sell before maturity, you are subject to principle appreciation or loss.
More Opportunity Cost Examples Using A $2 Million Investment
1) S&P 500 index. The index is currently yielding roughly 2%, therefore, you would get $40,000 in dividends each year. You expect the S&P 500 to return +/- 10%. Therefore, your potential return is -8% (-10% + 2% yield) to +12% (+10% + 2% yield), or -$160,000 to + $240,000.
However, if you bake in the opportunity cost of losing a guaranteed 3% return on your $2M, the true expected return on your S&P 500 index is therefore -11% (-10% + 2% yield – 3%) to +9% (+10% +2% yield – 3%) = -$220,000 to +$180,000.
2) Real estate crowdfunding. You can buy individual deals or you can invest in various types of funds. One of my favorite type of funds are the eREITs offered by Fundrise. eREITs make it easier for all investors to invest in real estate crowdfunding by region or goals. My expected return range is -$100,000 to +$200,000.
If you bake in the opportunity cost of losing a guaranteed 3% return on your $2M, the true expected return on my real estate crowdfunding investment is -8% (-5% + -3%) to +7% (+10% – 3%) = -$160,000 to +$140,000.
In other words, opportunity cost makes the downside loss even worse and the expected returns not as great. Real estate crowdfunding is my favorite passive income source at the moment.
Principal Appreciation Is Needed
The opportunity cost of not investing in a risk-free asset isn't as impactful when asset prices are rising rapidly. However, as soon as interest rates start to rise and the pace of asset appreciation starts to slow, opportunity cost means everything.
When the 10-year bond yield was at 1.5%, the risk-free opportunity cost was insignificant. Investors preferred taking more risk for a potentially higher rate of return. But with the risk-free rate at ~3%, it's finally starting to get more enticing to lower one's risk profile.
The key is to amass enough capital to the point where taking excessive risk is no longer necessary.
Think about a scenario where you have $10 million liquid to invest and could live happily on $250,000 a year in gross income. Why would you bother putting most of your $10 million in risky assets like stocks and real estate that could lose you millions, when you can earn $300,000 a year risk-free?
In such a scenario, I would invest 40% of the $10 million in risk-free treasury bonds, 30% in AAA municipal bonds, 20% in stocks, and 10% in alternative investments. Do this and you'll lead a care-free happy life, which is what having money should provide.
In conclusion, opportunity cost is not just about lost guaranteed money, it's also about lost time and happiness. The older and wealthier we are, the more we should care about the latter. After the age of 50, it no longer makes sense to hustle so hard because you already put in your dues.
Calculate Opportunity Cost With Empower
Sign up for Empower the web’s #1 free wealth management tool to get a better handle on your finances. In addition to better money oversight, run your investments through their award-winning Investment Checkup tool to see exactly how much you are paying in fees.
I was paying $1,700 a year in fees I had no idea I was paying. After you link all your accounts, use their Retirement Planning calculator that pulls your real data to give you as pure an estimation of your financial future as possible using Monte Carlo simulation algorithms.
Invest In Private Growth Companies
Finally, consider diversifying into private growth companies through an open venture capital fund. Companies are staying private for longer, as a result, more gains are accruing to private company investors. Finding the next Google or Apple before going public can be a life-changing investment.
Check out the Innovation Fund, which invests in the following five sectors:
- Artificial Intelligence & Machine Learning
- Modern Data Infrastructure
- Development Operations (DevOps)
- Financial Technology (FinTech)
- Real Estate & Property Technology (PropTech)
Roughly 35% of the Innovation Fund is invested in artificial intelligence, which I'm extremely bullish about. In 20 years, I don't want my kids wondering why I didn't invest in AI or work in AI!
The investment minimum is also only $10. Most venture capital funds have a $250,000+ minimum. In addition, you can see what the Innovation Fund is holding before deciding to invest and how much. Traditional venture capital funds require capital commitment first and then hope the general partners will find great investments.
Subscribe To Financial Samurai
Listen and subscribe to The Financial Samurai podcast on Apple or Spotify. I interview experts in their respective fields and discuss some of the most interesting topics on this site. Please share, rate, and review!
For more nuanced personal finance content, join 60,000+ others and sign up for the free Financial Samurai newsletter and posts via e-mail. Financial Samurai is one of the largest independently-owned personal finance sites that started in 2009.
It is interesting to see how you have evolved over the last 10 years since your investment philosophy has changed a lot since 2008. The constant is that you view financial independence and your desire to spend time with your family as the main thesis.
Hi,
Problem with your analysis is that 10 year treasuries are not risk free.
Given the state of debt in the US and the world, treasuries risk return is less than historically assumed.
Agree. Even Zeus dies.
What do you think is risk free? And when do you think the US implodes?
That’s an excellent allocation on the $10 million liquid assets to invest. I can surely live on a $250k/year income. What would you do if it’s $5 million? Would you do the same? Let’s say age is 50 with $5 million to invest.
This is probably one the main reasons why I haven’t invested in an actual property and prefer REITs instead. You don’t need to put up a big down payment, you don’t need to spend time and energy with tenants, and you don’t need to work on the property from time to time to keep up with maintenance. I know these things can be outsourced for a fee, but I won’t fee in control and that is kind of an opportunity cost for me to consider as well. :-)
“But with the risk-free rate at ~3%, it’s finally starting to get more enticing to lower one’s risk profile.”
Yep. Protection of your existing wealth, pure and simple.
Hi, Sam. I have been reading you years now and also made a couple of random comments in some previous posts. From the time I started reading, my stock investments have increased significantly(from practically nothing) and I am looking for alternative investments this year. I am looking for a somewhat easy way to buy treasury directly, which is what I presume is what you mean when you write about investing in treasury in your above post.
Could you at some point do a primer about buying treasury? I come across a lot of online FIRE blogs that talk about investing in stocks through Vanguard indexing, etc. But never hear anything about investing in treasury and how people go about doing it as easily as index investing through Vanguard.
I really know nothing on this, so I am looking for something that would point me in the right direction. I have always loved your writing and how clearly you explain things, so was hoping you’d be interested in helping people like me to further expand our investment portfolio into a different area/vehicle.
From what I’ve read so far, investing in treasury is not as straight forward as index investing unless I invest in a fund. What if I only want to invest in individual treasury, rather than a bond fund?
If my question seems too simple, then I hope you can help clarify because I have a lot of learning to do in this area.
Thanks for your insightful writing.
Here you go: https://www.treasurydirect.gov/indiv/research/indepth/tbonds/res_tbond_buy.htm
“In such a scenario, I would invest 40% of the $10 million in risk-free treasury bonds, 30% in AAA municipal bonds”
I tried logging into the treasury direct site and it was a major pain in the ass, I totally got lost.
Has anyone considered just buying vanguard treasury funds? Vanguard is just really easy to buy from. If so, any recommended funds. What risk would you run if the majority of the fund is US treasuries?
You can buy treasury bills through Vanguard or Fidelity as well. Fidelity has a very nice user interface.
Hi Sam,
Yeah, people often forget about the opportunity costs, often totally ignore lost time and happiness. All they see is the dollar signs… but at what cost?
I 100% agree with you when you say that “the key is to amass enough capital to the point where taking excessive risk is no longer necessary.”
But the big question remains: how to get there?
thanks for sharing your thoughts,
Ricardo
That’s a good question. In another blog, a physician with a family of 4, making $400,000 a year, living in a low cost area, investing smartly into S&P 500 during one of the longest bull market, took 10 years to accumulate $2,000,000 of net worth.
To get to $10,000,000 in 10 years requires a windfall, leverage, and some luck.
Although stock is the sure and best way to invest, you often hear people get rich off real estate because of leverage. With $50,000 to $100,000 down on a few $500K house in the right market at the right time can yield close to a million dollar return. In many areas a 500K house appreciate to $800K. That’s a $300K return off $50,000 investment.
I am not advocating real estate, especially in the current market. However it is one of the ways someone with a small net worth can multiply assets quickly.
Same thing can happen with stocks, but it’s unlikely someone with $50K would invest all his networth in Amazon, while it is likely they will buy a house with all their money.
Other than that, you got to get your windfall somewhere. Plenty of people who work for tech companies saw their stock option shot up to millions of dollars and cashed out. Or you could have sold your business for couple of million.
Realistically normal saving and investing won’t get you the magical $10 mil at a young age. Got to keep an eye out to make a large chunk of $ somewhere, leverage wisely, and hope you are lucky.
A good reminder of this concept and good examples of calculations. I was thinking about this when I read your last post, especially regarding what people spend on cars over the years before they buy a house and before they have their retirement plan funded. The opportunity cost of living where you need reliable cars (minimum 2 per family usually) just to get groceries, go to work, school, etc. is sizeable. Nobody thinks about this or mentions it at least when advising people to live where you can buy a great house for 10% of what it costs in a big city. Living in the city, you can get away with driving a small car for 28 years like I did and spend and/or invest the money not spent on cars. The cost of debt (car loans) is not only the interest, it is the cost of losing some leverage when it comes to getting a mortgage or line of credit.
The decision whether to put money into real estate, stocks, or “safe” bonds has another aspect for me in addition to returns including opportunity costs. I would not expect the same return from each of these, but still think I should diversify. Each has somewhat different advantages, risks, and income tax treatment.
As for those bonds, I would consider this if I had the capital you have, but I don’t feel comfortable going into old age with what I have so I am still accumulating. But if you have a large amount of capital, and will definitely be able to hold to maturity if bond prices go down, bonds make sense, especially if tax free. Otherwise, equities are better for growth and deferring taxes especially in a rising rate environment.
Great post Sam, the funny thing I that my personal asset allocation is similar to the $10 million portfolio you characterized in the post, though I haven’t $10 million!
I’m with you on opportunity costs. I admit though that I’m investing in more and more real estate crowdfunding deals. I love the flexibility of cherry pick8mg deals, based on location, payout, risk or what have you. I now have 28% of my net worth in these deals and Im loving the cash flow.
A few thoughts…
After a decade of work in high stakes finance and another half dozen years as an investor you just now realize the concept of opportunity cost?
Investing 2M in 3% treasury bonds may yield $5,000 a month nominal but only about $1,000 real income. The remaining $4,000 would have to go towards covering the 2% inflation rate, unless you want to see the real value of your 2M capital decline. Not to mention the possibility of future inflation rises once you get locked into that treasury bond for 10 years. Any inflation above 3% would turn your real return negative, or you could then sell the bond at a roughly 10% discount for a different type of loss.
The real estate taxes are indeed a different story. At $25,000 per year it is more than the maximum a person may put away in a typical 401k. So, essentially by buying that house you would be throwing away an entire 401k into real estate taxes. Will you be able to recover that lost 401k through housing price appreciation? I’m not saying the answer is no but a yes does involve a lot of speculation.
And talking about speculation, are the coming mandatory earthquake retrofit rules the needle that perhaps pricks the Bay Area property bubble? Just a thought.
No, but opportunity cost is something I haven’t written about it a long time. Hopefully this helps other people think about their investments.
One of the fallacies readers have is that they assume an article at any given point in time is all about the writer knows. But I probably have 100 times more things I could write or talk about, but I don’t bother, like most people who don’t bother sharing their thoughts.
There is an opportunity cost on the opportunity cost.
Do you have family btw? If you would like to ride I guess post, send me some ideas. It seems like you have a lot to say.
Novel way to approach large investments. I agree that as interest rates rise (which is inevitable I feel), your opportunity cost also increases making potential investments less attractive.
What are you thoughts though with regards to inflation in an interest rising setting? Everyone says equities are the only true way to increase/preserve wealth with typically the highest real returns. If you are just invested in a conservative vehicle like a treasury bond, will you not have erosion of your money because of inflation?
Of course if you have a large enough outlay of capital, the erosive effects of inflation are likely to be minimal. But most of us will be in the same boat where unless we can have real returns significantly above inflation, we may have to face lifestyle changes in our golden years.
Smart writing that letter! Writing always helps me make decisions. Good call on taking into account various opportunity costs before making a big investment. When you put the opportunity costs out there like you did in your situation decisions become much clearer. Great points!
I’m 52 -crunch time- for retirement savings. It seems for now everyone in my life is off the payroll -for now -and my focus is 100% saving and investing for the future which is why I love reading your posts! Sam if you had $50,000 where would you put it today? Not enough for Real Estate- Stocks seem over heated. What would you do?
Just an FYI-The div yield on the S&P 500 is sub 2%. Great article and thought provoking as always.
Great post
Sam,
What are your thoughts on buying a vacant lot in a rapidly gentrifying neighborhood for cash? Purchase price would equate to roughly 6-8% of total assets with the intention of holding and selling to a developer at a later date. Would look to create an LLC to make the purchase. Lots currently for sale purchased even just 12-24 months ago are selling for almost double the initial purchase price. While it is in large part a speculative investment, I can’t foresee the value decreasing (it’s in the path of development, near a park and public transportation), but the question is analyzing the opportunity cost of putting that money to work elsewhere (down payment on a rental property that generates cash flow, investing). Thanks.
What is the opportunity cost?
You would have to deal with the permitting process and the scores of enviro-nimbys that would show up at city wall hearings trying to shoot down your project. That’s a huge risk. Even if you do finally prevail your property could be tied up for years accumulating opportunity cost, not to mention loss of sleep.
There is a reason why real estate is so expensive in places like San Francisco — and it’s mostly the making of the very people themselves.
Some interesting points and perspective…,but I always question why people refer to treasuries as “risk free”.
If interest rates rise by just 1%, a 10 yr treasury loses 10% of its value.
Are you saying there is no “risk” that interest rates will increase from these historically low levels?
Unless you think the US will default on their obligation, there is no risk. You need to hold to maturity to get 100% of your principal back.
What risk-free investment would you choose?
Tremendous opportunity cost to hold a 10 year treasury to maturity if interest rates increase while waiting. (Which is very likely right now given historical comparison)
Everyone seems to ignore this pesky little fact when they explain that you can get 100% of your principal back if hold to maturity.
To your question, I guess I could be guaranteed to get 100% of my principal back if I hid it underneath my very safe mattress.
Inflation kicks both treasuries and cash in the butt long term.
Short term the differential is less so it’s less of an issue in my mind.
What he means is that there’s no risk in the long run.
In classical interest rate vs yield calculations, if the interest rate changes, the price will will adjust accordingly so that the final amount at the end of maturity will be the same.
On the other hand, if you are forced to them them before maturity, then yes, they could be very risky (though usually not as much as stocks). You could easily see 10-15% swings up or down for each 1% change in interest rate. The longer the term, the bigger the change when you sell early.
Thanks for sharing your thinking process. I think the $2M house isn’t a good deal at the top of the market. The running cost is too high and the appreciation is topping out. It makes a lot more sense when the housing market was rising rapidly.
I haven’t thought of opportunity cost in term of lost time and happiness. You probably have to be rich first to think of it that way. For the regular people like me, opportunity cost is all about money.
If the owner came back with a counter at 2.3 million from a list of 2.2 million, it would be an insult.
Nonetheless with the numbers you provided I don’t see the value in the purchase either way. Right now I believe we are in a meltup with real estate. People I know are just throwing there houses on the market way over value hoping someone just happens to really want it with an inflated price.
Well, at $2.2M, the house would sell for only $562/sqft. That’s a 30% discount to the neighborhood, but it doesn’t have an enclosed yard, and it needs a lot of work.I think they’ll ultimately get about $2M for it.
Great post Sam, I think I play some of this mental math myself when agonizing over a big purchase. I bet you really caught that real estate agent off guard when he read the paragraph in your letter about the risk-free 10-year treasury bonds yielding 3%. He was probably saying “where is this guy coming from…”
I would love to have enough to just be able to coast of treasury bonds and have zero risk