Opportunity cost is a spender's greatest enemy. Given America has a spending problem, our country will constantly be in grave danger without adopting better financial habits.
Back in 2018, I decided to join a Meetup softball league in San Francisco. I was one year into being a stay at home father and I needed to get out of the house more. Tennis had always been my sport, but I thought it would be nice to mix things up.
The softball league turned out to be a great outlet. I met people from various parts of the Bay Area from different socioeconomic backgrounds. The person I developed the best relationship with was with the organizer named Bob.
Bob is a preschool teacher who helps manage some of his parents' properties. As a property fanatic myself we talked about various investment opportunities.
Of course, I shared my enthusiasm for ocean view properties in San Francisco. Then I mentioned my heartland of America investment thesis. Who knew that today's global pandemic would accelerate the demographic migration towards lower-cost areas of the country.
The Arrival Of A New Tesla
Then one September 2018 weekend, Bob showed up for the game in a brand new red Tesla Model 3. The Model 3 had just come out and Bob crowed on and on about how amazing his car was. He even showed me how he could back his car up using his iPhone while standing outside.
I was impressed! But at the same time, I was dismayed that he had spent $53,000 for a car.
As the creator of the 1/10th rule for car buying, I strongly believe that paying much more than 10% of your gross salary on a car is a poor financial move. Paying too much for a car is probably the most common financial mistake Americans make today.
I didn't know exactly how much my friend made, but I was sure he wasn't making over $530,000 as a preschool teacher. As a 32-year-old preschool teacher, my guess is Bob makes about $70,000 a year. In other words, Bob spent a whopping 75% of his gross income on his new ride. The percentage is even higher if you calculate based on his after-tax income.
As a new friend, I wasn't about to judge Bob for his purchase. Instead, I just listened to why he loved the car so much. His enthusiasm was as high as a bench warmer who had just hit the game-winning single.
The True Cost Of Owning A Car
The true cost of owning a car isn't just the cash necessary to purchase the car. Other costs include:
1) Monthly payments
If you don't pay 100% cash for your car, you've got to pay a fixed monthly lease or loan payment. A lease payment is made to basically rent the car and return the car back to the dealer after a certain time period with zero equity. If you want to terminate the lease early, you will likely have to pay an early termination fee.
A loan payment, on the other hand, slowly pays down the debt owed on the car. Although you will eventually own the car outright, if you have an interest payment higher than 0%, your total cost to own the car will be much greater than had you paid cash up front.
Depending on your warranty, you will have to pay for oil changes, flat tires, and broken parts. Once, I had to spend $700 to fix my car fan because it inexplicably stopped working three months after my warranty expired. Murphy's Law of course!
3) Auto Insurance
If you plan to drive your car legally, then you must get car insurance. Even the most basic liability insurance will cost you several hundred dollars every six months. If you want comprehensive insurance, where your insurance covers all vehicles involved in an accident, expect to pay much more.
4) All Sorts Of Tickets
If you drive in a big city, expect to get everything from parking tickets to traffic tickets. Traffic and parking tickets are important revenue sources for the city.
It is not a mistake that some parking instruction signs are difficult and confusing to understand. If you don't get a parking ticket, you will likely get a street cleaning ticket. If you don't get a parking ticket or a street cleaning ticket, you may eventually get a moving violation ticket for not coming to a complete stop at a stop sign.
With budget shortfalls a very real concern due to shelter-in-place, expect the ticket police to be in full force once the economy reopens.
Heaven forbid you ever get into an accident. However, the more you drive, the more likely you are to get into an accident. If you do get into an accident, expect to pay your full deductible. Once the insurance company covers the cost of repair, expect to get charged a higher semi-annual premium during the next coverage cycle.
I once accidentally scraped the side of my Honda Fit on a parking pillar while backing up. The total cost to straighten out and paint two panels was roughly $3,400! My $1,000 deductible was easily met and my car insurance premium went up for the subsequent 6-month insurance cycle.
Biggest Cost Of Owning A Car: Opportunity Cost
All of these costs are why following the 1/10th rule for car buying is important. If you keep your car purchase low enough, you can withstand practically any cost or surprise cost on the list above.
But there is one cost that may trump all other costs combined: opportunity cost!
After hearing Bob go on and on about how great his Tesla Model 3 was for three weekends in a row, I decided to test drive one to see what all the hype was about. Electric cars are awesome!
The test drive was an experience like no other. Driving a Tesla makes driving an internal combustion engine car feel so antiquated. Not only is the ride powerful and smooth, but every time there is a software update, the car performance gets a little better.
In honor of Bob's purchase, I announced on the FS Forum that I decided to buy about $30,000 worth of Tesla stock in October 2018 at $298/share. Then I decided to buy about $25,000 more stock for about $330/share because I had investing FOMO. I wanted to buy about the same dollar amount of stock as Bob had spent on his car.
Surely, the stock was going to be a winner!
Tesla ended up rising to $367 a share shortly after, making me a cool $11,500 on paper. During the next six months, Tesla began melting down as fears of bankruptcy emerged. By June 3, 2019, Tesla was down to just $179/share. My $11,500 paper profit had turned into a $20,000 paper loss!
Once again, I was reminded that trying to pick individual stocks to outperform the S&P 500 is a fool's errand. Luckily, the market has started to recognize the potential of Tesla's growth and re-rated the stock in 2020. One thing shareholders do know is that owning Tesla stock is going to be a very bumpy ride!
Opportunity Cost Is Painfully Real
Although purchasing a Tesla car versus owning Tesla stock is perhaps an extreme example of missing a potential investment gain because you instead purchased an over-priced car, understanding opportunity cost is critical for controlling your spending.
Since 2009, the S&P 500 has been on a tear. Therefore, almost at any point since 2009, you could have invested in the S&P 500 and made more a year later.
Of course, there will be some bad years like in 2018 and in 2020 so far. However, over the long term stocks tend to go up at an 8%+ annual rate. Meanwhile, you can always invest in bonds, real estate, or other investment classes that have also historically gone up over time.
Below is a snapshot that shows the good and the bad of owning Tesla stock. After rising to $917/share on Feb 19, 2020, the stock quickly plummeted down to $361/share on March 18. I had given up almost all my gains. I was bummed.
When Tesla rebounded to $888/share on June 5, 2020, I told myself I've gotten really lucky. Given you can never lose if you lock in a gain, I decided to start selling some shares.
8 is a lucky number in Chinese, so I figured at a share price of $888 and an unrealized gain of ~$88,000, this had to be an sign!
Alas, we all know what happened next. Over the next 30 days, Tesla's share price rocketed 70%+ higher to $1,500/share! I essentially left about $80,000 on the table because I by then only had a measly 30 shares left.
Talk about terrible timing. Now watch me give up all my gains because I've decided to hold my remaining shares forever.
Always Calculate Opportunity Cost
Before spending money on anything significant, calculate all the direct costs associated with owning the item. Then calculate the potential opportunity cost because the opportunity cost could really be a killer.
Even if I didn't buy $55,000 of Tesla in 2018, I could have bought the S&P 500 which ripped higher by 30% in 2019.
If you haven't reached financial independence yet, then paying much more than 1/10th of your annual gross income on a car is not a great move. You could have invested the downpayment or the monthly payments in stocks, bonds, real estate, or other asset classes that have historically appreciated over time.
As for my friend Bob, he actually is experiencing the best of both worlds. Not only is he enjoying his Tesla Model 3 every day, but he also revealed he's a Tesla shareholder!
An Investor's Lament
Looking back, it's crazy to think that so many of us could have gotten extraordinarily wealthy by investing in Tesla and many other tech stocks in March 2020.
These investment opportunities are why I will consistently try and invest ~10% of my investable assets in individual stocks and other opportunities. These random opportunities are why we should always set aside a nice cash hoard as well.
Index investing is nice, but if that's all you do, you're never going to outperform the masses who own index funds. To gain real wealth, you must outperform. You can either outperform in your investments, your career, or your business. You might as well try and outperform in all three.
Of course, you might underperform with your individual investments. However, that's what getting rich is all about. Taking calculated risks beyond the average person. Good luck!
Update 2021: I so should have held onto all my Tesla stock! I would be up another $200,000 at least if I did. The stock looks like it's in a total bubble. However, bubbles tend to grow far beyond expectations. As of now, I have $130,000 of Tesla stock.
Recommendation: Get lower auto insurance through Allstate. Auto insurance is one of the largest ongoing costs of owning an automobile, in addition to gas and maintenance expenses. Always try and get the lowest auto insurance possible.
Readers, do you have a great opportunity cost story to share? How do you balance saving and investing money versus spending money on a better life?