When it comes to managing money, investing, and life in general, there are a number of psychological factors at play. Understanding these factors can help you make better money decisions. Two of the most important concepts to understand are opportunity cost and sunk cost. We’ll cover both here.

What is opportunity cost?

Every time we make a decision, we are giving up the options we don’t choose. If you decide to go on a ski vacation, for instance, you’re giving up the chance to spend that same vacation at the beach. Not going on a beach vacation is one of the opportunity costs associated with choosing a ski vacation.

To use a monetary example, when we decide to spend money, we’re giving up the chance to invest it (and all of the potential returns that might come with that investment). When you decide to save or invest money, you’re giving up the chance to spend it on something that could benefit your life today.

This type of interconnectedness is one of the reasons we at Revo Financial say there’s no such thing as an independent financial decision.

Opportunity cost in investing

In more formal economic terms, opportunity cost is the benefit you lose by not choosing something. In investing terms, say you have a fixed amount of money, and you decide to invest in an S&P 500® index fund. By deciding that, you’re giving up the chance to invest that same money in a bond fund — making that bond fund (or any other potential investment) the opportunity cost.

Opportunity cost can affect how satisfied we are with our choices. Investing in the S&P 500 may have been a great decision for your portfolio. But if the bond fund you didn’t choose happens to outperform the stock market during that period, you might start to feel less satisfied with your choice to invest in the S&P 500.

Opportunity cost affects selling, too. Say, you decide to sell part of your stake in the index fund because you need cash on hand. If the stock market jumps in value the next day, you may be tempted to focus on those missed gains — or missed opportunity.

You can see why opportunity cost has the potential to impact our happiness and satisfaction in a major way. It’s a classic variation on the “fear of missing out,” which is a real risk, especially for investors who are focused on managing risk.

When these situations arise, it’s helpful to both identify the fear of missing out for what it is — opportunity cost — and to stay focused on the big picture. Remember: You are giving up that opportunity in order to focus on something more important to you.

That’s one of the many benefits behind our values- and faith-driven approach to investing. When you select investments that align with your values, you may miss out on some potential returns (opportunity cost), but you know that your investments align with your overall values. We can also help you assess how investment performance is lining up with your overall financial goals.

Sunk cost

Another obstacle to potential happiness with our finances? Sunk cost. This is related to opportunity cost. Essentially, this is a cost you won’t recoup regardless of what you do next. However, many of us are attached to this initial outlay, the sunk cost, and make decisions to try and justify it.

Consider that ski vacation. Let’s say you paid for an all-inclusive hotel, where meals for you and your family are covered. That expense is paid whether you enjoy those meals or not — it’s a sunk cost. There are also opportunity costs associated with it, like deciding to try local restaurants. You may decide it’s worth it to go out to dinner one night of your trip because you want to take advantage of that opportunity, and you know that the included meals are a sunk cost no matter what.

There are other big-picture examples of sunk costs: closing costs on a house, for instance. You’ve paid those regardless of whether you stay in the house one year or five years. If you decide to move within a few years, you won’t be able to get that money back. It can be tempting to beat ourselves up about sunk costs if we aren’t happy with the associated decision. However, these costs are simply an actuality in life. Oftentimes, sunk costs that don’t go our way offer, at the very least, insights for how to make better money decisions next time.

How Revo Financial can help you make better money choices

Opportunity cost and sunk cost are just two of the psychological factors at play when it comes to money decisions. That’s one of the reasons working with an advisor can help relieve some of the pressure. We walk you through the ins and outs associated with different investments, big purchases, and more.

Our approach to this is collaborative in nature. We want you to have all of the information you need to make an informed decision. We’ll make a recommendation based on our expertise, and provide the tools and research to help you better understand your options. Ultimately, however, these decisions are up to you. You know yourself and your goals better than anyone.

Remember: Most financial decisions, from where you put your money to when you decide to retire, are about much more than finances. There is a mental, emotional, and family component to everything. And that’s part of why we wanted to share this framework for how to think about different choices.