If you slept through economics, or didn’t take it at all, you missed some surprisingly important concepts for handling your money day to day. Here are three Econ 101 terms you should learn now.
1. Sunk cost. This is money that we've paid or invested that can't be recovered. If we were entirely rational, we wouldn't let sunk cost influence our decisions -- but often we do.
An example: You spend $100 to see a Broadway show. By intermission, you're bored out of your mind. A rational person would leave the theater and find something more fun to do, but many of us irrationally return to our seats because we spent so much money to get them.
Sunk cost is an especially important concept when it comes to investing and real estate. We may resist the idea of selling for less than we paid, even though the money we spent is gone forever. A more rational choice would be to see that money as lost, and focus only on our next move. Is the stock that has lost half of its value likely to rally? Is the home that's dipped in value still affordable? Would we make the same investment today, or are we better off selling for what we can get and redeploying the money elsewhere? Taking sunk cost into account can help us avoid throwing good money after bad, or watching a lousy investment sink further in value.
2. Opportunity cost. Every choice you make means giving up all the other possible options. Your opportunity cost is the value of the best alternative you didn't take. If, for example, you decide to go to college after high school, you give up the money you could have made working full time during those four or five years that you're in school. Since a college degree offers vastly improved lifetime earnings, even after its costs and foregone wages are considered, it's an opportunity cost well worth paying.
Other times, considering opportunity cost can help you change course to make better decisions. Let's say your car is 5 years old. Buying a new one would set you back $32,000. With a 10 percent down payment and 2.99 percent financing over five years, you'd pay about $517 a month. Now let's say instead that you put off replacing the car. Instead, you invest what you would have spent on car payments into your retirement account. After five years, you'd have about $38,000, assuming 8 percent average annual returns. In 20 years, that pot could grow to about $187,000 -- all from a one-time decision to keep your car for 10 years instead of trading it in after five.
3. Risk and return. Simply put, the safer the investment, the less you'll be compensated for handing over your money, all other things being equal. The higher the promised or potential return, the more risk you're taking of losing some or all of your investment.
Typically, investments that offer the least risk of losing principal offer such low returns that you face another risk -- inflation eroding your buying power. Bank accounts and Treasury securities insured by the Federal Deposit Insurance Corp. usually pay interest that's less than the inflation rate (sometimes much less).
Understanding the relationship between risk and return can help you make smarter investment decisions, such as keeping your emergency fund in a safe account (since you don't want to risk losing it right when you need it) and taking more risk with your retirement account, because investments in stocks offer inflation-beating returns over time. You also should be able to avoid scams that promise "high, risk-free returns," since you know those don't exist.
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