Opportunity Costs

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Opportunity Costs

Postby assumer » Sat Mar 16, 2013 10:34 am

I'd like to start a discussion about opportunity costs, specifically in regards to things with annual contribution limits, such as IRA's or I-Bonds.

Let's assume the following for the sake of discussion.

Assumptions:
1. You have a guaranteed $10k bonus at the end of this year, and a guaranteed $30k bonus at the end of next year.
2. You have a 10k loan at 5%
3. I-Bonds are currently paying 2%

Options:
1. Pay off the loan the first year, and then use the $30k next year for $10k in I-Bonds and $20k in another investment.
2. Buy I-Bonds both years, and pay off the loan at the end of the second year, leaving $10k for another investment.

In both options, at the end of year 2, you will have paid off the loan, and $30k left over invested

Mathematically, the higher expected value is to pay the loan first. However, you will then forever lose the opportunity to have that extra $10k in I-Bonds. What if a few years later you wish you had money invested in I-Bonds instead of an alternative investment?

How should one think about this? Simply always maximize the current EV and not worry about opportunity costs?
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Re: Opportunity Costs

Postby jwa » Sat Mar 16, 2013 12:31 pm

I think this can be an interesting topic to discuss and I look forward to the dialog that will ensue. However, for me, I recognized opportunity costs in some of my short term decisions in the past and acted accordingly. I must say, though, most of the time I didn't and even more so when the time horizon went out into the distance. To do so I would have to analyze various scenrarios, come up with estimates and then guess on the optimal outcome. Too much analysis which often led to paralysis. I just tried to pay my bills, raise my kids, get out of debt and dollar cost average the S & P 500 over the years with Vanguard.

Now that I am older, one of my heroes in life, Taylor Larimore, has convinced me here at the forum of the wisdom of the 3 fund portfolio and I've acted accordingly. I guess I wasn't inclined to sweat the details and instead followed time tested general rules and it has worked out for me well enough. That's just me as I have longed enjoyed the position of being a passive investor and not sweating the details but that's my nature. Like I said at the beginning, I am looking forward to see where the discussion goes.
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Re: Opportunity Costs

Postby Aptenodytes » Sat Mar 16, 2013 12:52 pm

There's a lot of irrelevant information here. The choice is between paying off the loan or not in year 1; if you don't pay off you buy I Bonds. The loan is effectively a 2-year term. The opportunity cost of paying off the loan is one year's interest from the bond. Ergo you pay off the loan.
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