The great thing about making decisions in life through the lens of decision trees and opportunity cost is that it allows you to focus on what you actually want. You tend to protect yourself against giving up what you really want for what you want right now. Everything in life has an opportunity cost. It doesn’t matter how young or old, rich or poor, successful or miserable you are. Opportunity cost is everywhere. At this particular moment, I am facing a situation that involves cars. It’s a perfect example of how those tools – decision trees and opportunity cost – can make choices easier, or at the very least, clearer.
Cars Are Terrible Financial Investments
First, I have a love-hate relationship with cars. The average American spends way too much on his or her car. I hate cars as a financial asset. It angers me that the standard American family has two vehicles, constituting the second largest asset on their balance sheet behind a primary residence. Cars lose value through depreciation. They require maintenance. They must be insured. They need fuel. Worse, they often require interest payments to a bank unless you write a check to cover the entire purchase price, which few families do. Thus, for a typical teenager, cars serve as a rite of passage into the indoctrination of the pay-as-you-go-easy-finance cult. Buying a car is like compounding in reverse. You end up poorer. The more you spend, the more you lose.
On the other hand, there is utility that can be gained from a vehicle. This is especially true if you are in a position to write a check for a car, have more than enough money set aside to grow for the future, and generally like automobiles. Years ago, the first car I bought myself was a Jaguar. I calculated exactly how many shares of stock I would be foregoing to pay for it and there has not been a single moment when I thought, “I wish I had invested the money, instead.” It’s been a great car. I’ve driven it throughout the United States, in all sorts of conditions, and very rarely been disappointed except for the fact that even the smallest repair seems to reach into the thousands of dollars. Likewise, Aaron loved his first luxury car, which was a brand new black Lexus. Even though both were enormously expensive in terms of future compounding given up, they were worth every penny.
Unfortunately, I find myself in the situation of now having to make a decision about cars. Mine needs some work. It is fairly extensive, which would require a decent sized check to fix. I could get it overhauled and still drive it another three to five years. That seems like too much hassle so I looked into getting something new. That way, I can just have the dealership take the existing car off my hands and get a trade-in credit for it. Plus, at this point, it is seven or eight years old and I wouldn’t be opposed to getting something with more bells and whistles as technology upgrades have now made significant advances.
Create a Baseline Against Which to Compare Your Options
To begin, I did some research and started with what I want, without consideration for the money involved. In terms of styling, the car I most like is the Mercedes M class of crossover vehicles. I calculated what it would take if I wrote a check for one, traded in the existing Jaguar, and drove it for 5 to 8 years, owning it outright. This is the baseline. This is the standard against which everything else is now compared.
For me, the baseline in the 2012 Mercedes M-Class Crossover.
The exterior of the 2012 Mercedes M-Class Crossover.
Then, I ran through a series of other scenarios. Here is a small sampling (click the image of the decision tree below to enlarge). The far right of the chart shows the extra net worth I would have by selecting that option instead of the base option, the Mercedes M class. For example, if I decided to write a check for a Ford Taurus, I would have an extra $3,222,954 by the time I reached my golden years by investing the difference between it and what I would have spent in the base scenario, assuming average rates of return and reinvestment of all dividends.
The reason this decision tree is so basic is because I have already taken some possibilities off the table. I could have even more money if I sold the Jaguar, bought a 20-year-old Neon, invested the difference, and ran around town with my bumper hanging off but that isn’t going to happen. Likewise, I love the Bentley Continentals but it would be idiotic for me to give up the kind of future compounding that would be required to own, insure, and maintain a care like that given my age. The two extremes thrown out left me with a decent range of options that seem reasonable to me.
Buying a Car Decision Tree. Consider that over a lifetime, you probably own half a dozen or more cars and it quickly becomes evident how big of an influence your driving habits have on your pocketbook.
To help improve my thinking, I sometimes frame the situation backwards. I use Benjamin Graham’s Mr. Market, asking myself, “If he walked in the door today, and said, ‘Joshua, I will pay you an extra $5,899,475 by retirement to drive a Kia Optima today rather than a Mercedes M crossover'”, would I accept those terms? What matters more to me, the nicer car or more money for myself, my family, my heirs, and my charitable foundation? It comes down to priorities. I can afford either scenario so what matters is what I value. What do I value more?
I know I harp on this a lot but there is no right or wrong answer. Whatever you (or in this case, I) decide to do is entirely about maximizing personal happiness. What, in other words, is going to bring me the most joy? The baseline scenario now or an extra $3.2 million, $5.899 million, or $7.17 million later?
Your Opportunity Cost Will Fluctuate Throughout Your Life
Over time, your calculus will change. Early in life, the opportunity cost of buying nice things was so high that, as many of you know, Aaron drove a 1993 Ford Escort that had hundreds of thousands of miles on it, no heating or air conditioning, and shook when he went above 65 miles per hour on the highway. Today, he wouldn’t consider that an option because 1.) he has less time to compound since he is a decade older, and 2.) he is much richer so the burden of buying a particular item is lower in an absolute, as well as relative, sense.
In my case, if I were 45 years old, this wouldn’t have even made it to the decision tree stage. I would have just bought the Mercedes M class because the future value of compounding wouldn’t have been worth the trade-off for me. The thing is, I am not 45 years old. I am 29 years old. This is why it is important you understand that opportunity cost is personal. If differs for every person. It will differ you at various times in your life.
Why do many people fail at their financial goals? They focus on the now. They say, “Sure, I can afford it easily” instead of, “Would I rather have [x]?”. That shift in your outlook can radically transform your life. Whether you are choosing a college, thinking about switching careers, starting a business, or buying a block of stock, always focus on the trade-offs; the opportunity cost of your decision.
To the extent matters can be controlled, your are the architect of your own financial destiny. When you buy a car, or even a television, you are making a multi-million dollar decision whether you realize it or not. The culmination of those decisions will help determine where you end up in life.
Footnote: I should point out that other factors come into play when buying a car, since that is the example we used in this discussion of opportunity cost and decision trees. If I were a young lawyer, financially successful, launching my own practice, I would buy an extremely nice car because of signaling theory. Potential clients who didn’t know me would most likely gauge my prowess by the way I dressed and the car I drove, making it easier to attract lucrative business. If I were running a scrap yard, I would purposely choose a beat down car or pickup truck to fit in with my clients so they didn’t think I was making too much money. That is another example of how opportunity cost could factor into your decision in ways that might be unexpected.
Reader Comments (21)
Comments are presented chronologically, with replies indented beneath the comments to which they respond.
Dexcook
April 21, 2012
I've been reading and enjoying your articles for several months now. I recall an article from MSN money several years ago with a similar theme: comparing the cost of buying new (or even leasing) every three years vs buying and driving for a longer period (I think 7 years or so). The article tallied up the difference between the options for an individual over the course of a lifetime, and it was surprising (not as high as the figures you provide, but the article didn't account for investment returns). Thanks for another great article, as usual.
Joshua Kennon
April 28, 2012
Replying to Dexcook
Welcome to the site!
Suh
April 21, 2012
you said last year you will make a list of the must read books to become a success and how you gained your knowledge, When will you write that post.
Joshua Kennon
April 28, 2012
Replying to Suh
Whenever I get to it.
I wish there were a more profound answer but most of the posts, and even the comment replies, are subject to my schedule and whatever topic I feel like discussing at the time.
Bensobolewski
April 21, 2012
Really great article
Joshua Kennon
April 28, 2012
Replying to Bensobolewski
Thank you, and welcome to the site!
Steve Hook
April 21, 2012
Awesome Josh. Love the article. One option I did on my vehicle was to lease and take all the discounts, rebates, trade money back in the form of a check and take a higher lease payment. This totaled 7,500 in my case. Now I just keep a total of my costs of the car. Payments, insurance, gas, etc. Once I get up the the 7,000-7,500 in expenses, I will look at my equity position and either sell it back or flip it into another lease and take out the cash again. In a sense I am able to drive for free for about 1.5 + years before having to have any out of pocket. Plus I have the use of the money during that time to collect interest, dividends and rents from. Good stuff hope all is well. Keep the articles running. I can say they are the cause for at lease half of my net worth today. I thank you. ---Steve Hook (Philly)
Joshua Kennon
May 9, 2012
Replying to Steve Hook
That's a high compliment, Steve. Thanks for reading!
T
February 2, 2014
Replying to Joshua Kennon
You never do tell us what choice you ended up making. 🙁
Ian Francis
April 23, 2012
This analysis really helps if you are able to place a value on your enjoyment. If you really like one car over another and can say you will get $xxx more enjoyment from car A over car B, then this becomes a simple plug-and-chug equation. My guess is this is very difficult to do for pretty much everyone. Also, many of those people reading and following this blog probably get similar enjoyment out of saving money in the first place, so that would likely counter the enjoyment of a more expensive car.
Guest
September 10, 2013
(I realize this is from a year ago...but) Great article - found your blog through About.com about 4 months ago and have read almost every post haha. In regards to the decision tree helping you decide on a vehicle - how do you factor in safety into the pro's/con's? An H2 Hummer would be more safe than a Smart Car but costs more to buy, maintain, run, etc. Or a Tahoe vs. an Accord, SUV vs. small/mid-sized car, etc.
I realize styling, tech features, reliability, mpg, and level of fit/finish also come into play when comparing multiple vehicles but again, just looking for your opinion on how size/weight/safety come into play.
Thanks,
Joshua Kennon
January 15, 2015
I'm sorry I didn't see this question for an entire year but in the off chance you are still on the site, I consider safety within the parameters of the type of vehicle I'm considering. If I were out to buy a pickup truck, the fact a Lexus is safer wouldn't really do me a lot of good so I wouldn't worry about it since, in general, trucks are still safe. That is, I'd pick the type of vehicle you want, then consider safety as one of the most important variables within the category.
JB
January 16, 2015
Replying to Joshua Kennon
So what kind of car did you end up getting?
guest
December 13, 2016
Replying to Joshua Kennon
I'm still here, thanks for the reply on the safety question! I think I will follow that logic "pick the type of vehicle you want, then consider safety as one of the most important variables within the category" when I eventually need a new vehicle.
Also, wanted to take this opportunity to thank you for all of your content over these past years - it has literally changed my life and I can't thank you enough. I only wish I found it sooner. I wish you and your family continued success. You will be missed when the "drawbridge" is raised.
Manderson
February 23, 2015
Hi Joshua, Love the site. I know I'm commenting on an article that's a few years old, but what RORI did you assume for your calculations? I'm trying to recreate your numbers/calculations for myself. Thanks for sharing your thoughts!
Joshua Kennon
November 4, 2015
Replying to Manderson
I'm so sorry I didn't see this comment until now; please forgive the oversight. I just responded to another person asking this same question, which you can read here.
Stephen H
August 21, 2015
What option did you go with? Also this is something I've really started to pay attention to and have decided to avoid buying a new car and instead buying something decent that is used and can save me 8 - 10000. I just drive it into the ground anyways.
Joshua Kennon
November 4, 2015
Replying to Stephen H
I ended opting to stay with the Jaguar. The car is definitely well-loved at this point but I think I can get another two years out of it, not having to do something through 2017, which would mean having to make a decision, again, in 2018. Once I made the last decision-round back in 2012, I put it out of mind and the temptation fell away except for a brief, window of time a couple of months ago. Aaron and I were driving near Aristocrat Motors in Kansas City and I had a strong urge to pull into the lot and buy something on the spot. I looked at him (he was driving, I was in the passenger seat) and told him if he stopped, we'd leave with a new car because I was having a moment of weakness. He said, matter-of-factly, "I'm not. I'd rather have more stock" then took the off-ramp in the opposite direction.
When you put two self-made over-savers in a single household, it takes a special alignment of the stars to get the checkbook to open. Knowing us, one day we'll wake up, look at each other, and go buy a matching set.
Bryan Allen
November 4, 2015
How did your math work for these calculations? By a rough estimate, a 7% average return over the 36 years you had until retirement at that point (assuming 65), and a roughly 20,000 difference between a Taurus and Mercedes M class only yields about 228k, not 3.2 million. I'm not factoring in things like decreased insurance and maintenance costs, but I have a hard time believing they'd ever make up that difference unless you're spending over 20k a year for both.
Joshua Kennon
November 4, 2015
Replying to Bryan Allen
It's been almost four years since this was posted so I'm going off memory at this point. I believe:
1. The difference between the two models you mentioned, the ones we would consider buying, was far more substantial than $20,000. Had we gone with the Ford, we would have gone standard model, whereas had we gone with the Mercedes, we would have pretty much purchased the top-of-the-line configuration (it might have been confusing because in this post, I referred to this - our default preference - as our baseline or base scenario, which sounds like base model; poor choice of wording).
2. When this post was written, we were sitting in what was still severe undervaluation territory for some of the best equities in the world thanks to the catastrophic collapse that had occurred shortly prior while bonds were in a bubble that all but guarantee after-tax, inflation-adjusted purchasing power losses over the next 20 to 30 years if held to maturity so a 7% rate of return would have been fundamentally irrational and academically foolish if one assumed the world, like it had so many times prior, would recover. My absolute base-line return requirement under almost all situations (the exception being strategic assets in operating companies we control, where the value might come into the picture in other ways that are hard to measure but nevertheless important), is the 6.5% real after-tax, after-inflation return equities have produced over long periods of time, encompassing everything from the depths of the 1929-1933 period to the absurdity of the late 1990's. (When someone like John Bogle of Vanguard mentions "reversion to the mean", that's the mean to which he is referring as it pertains to equity allocation).
Therefore, I would have absolutely required a hurdle rate of somewhere around 10% per annum in nominal terms and assumed a 100% equity allocation as my cash and other needs are already provided in full. In reality, given my unique opportunity cost (hence the big bolded reminder in the post itself) that allows me to start or acquire whole companies, invest in real estate if I desire, or look at partial ownership of businesses in the form of common stocks, my real-world hurdle rate effectively ends up being higher most of the time (e.g., one of the first businesses we started with a few thousand dollars out of pocket went on to produce millions of dollars in cash flows that funded other opportunities - something a typical worker doesn't have in the cards due to a lack of ability or desire to be what Dave Thomas referred to as "an operator") but I never would have assumed the higher rate for an illustrative situation like this. Over nearly four decades, that 3% per annum differential would result in exponentially more money. Applying it to the much larger than $20,000 price differential we've already discussed, that almost assuredly closes most of the gap.
3. Since I don't plan on retiring - I've never, technically, had to work in the traditional sense in the first place due to Aaron and I being a non-negotiably independent and setting up systems that produced large amounts of money relative to effort and capital in those early years - I might have tied the terminal year to the highest Social Security age, which was 67 years old at the time, rather than 65. Don't quote me on that as I'd have to re-run the numbers to double check. In any event, it would be practically meaningless since most of the money is going to end up going to charity and our future children and grandchildren. Additional years added to the end of a compounding calculation produce disproportionate influence relative to the base amount as you are dealing with larger sums.
To be perfectly frank about it, the $3.2 million in our case will almost assuredly end up being significantly understated. Some of the things we were buying in 2012 were near once-in-a-lifetime attractive valuations, including augmenting the Wells Fargo stake we had been purchasing since the meltdown given that it was so far below it intrinsic value it bordered on the absurd as well as a private operating buyout of the shareholders of one of our controlled companies, leaving Aaron and I as the last owners standing, make the illustrative nominal rate fail to reflect reality.
All of that said, were I running a valuation scenario today, at today's equity and bond prices rather than 2012 when this was posted, and I were an average office worker who had nothing but a balanced or so-called "three fund solution" available as a way to inventory and compound past retained earnings, I might even consider 7% per annum a bit optimistic unless the money was being fed in over time, through some sort of dollar cost averaging program rather than a lump sum. For a pure equity allocation, I wouldn't go that far because in the history of American equity markets, including the worst collapse in 600 years, there has never been a 25-year period when nominal returns were 6% or less for a buy-and-hold investor. There's no guarantee it can't happen - look at the stock market of Austria during the 20th century where effective wipe-out occurred due to geopolitical events - however, in such a scenario, we have much bigger problems about which to worry and a person might have other things in place to guard against such an outcome making an apples-to-apples comparison impossible, if not outright inappropriate.
If you would be considering two models only $20,000 apart, and if you believe your personal likely rate of return is 7% per annum, and if you have 29 years until retirement, it would be entirely reasonable to make a trade-off decision based upon the lower amount you mention as, again with the bolded part in the text, that would be your personal opportunity cost. Every person and family must make its own trade-off decision relative to what is on their desk, not their neighbor's desk. It's entirely possible for utility levels to differ based on personal ability, investment choices, and personal preferences.
Bryan Allen
November 5, 2015
Replying to Joshua Kennon
Thank you for breaking down the logic that went into it in such detail, it is very interesting to see how you reached your personal numbers. I had taken the article to imply a rough opportunity cost for an average person based purely on cost of vehicle, paying up front or over time, and additional expenses involved based on vehicle choice. And to raise or lower the numbers from there based on personal situations and priorities. I didn't realize your situation could be considered an extreme statistical outlier, where it probably doesn't apply to very many others and affected the numbers to such a degree. I came across it while trying to calculate investment opportunity costs for buying new, buying used, or leasing, and paying more or less up front. I thought I might be missing something when running my personal numbers and coming up a few million short. Thanks again!