Have you ever heard of the term used by economists called ‘Opportunity Cost’? This is where you have a number of options available and you decide to choose one of them. The opportunity cost is the difference in value between the option you have chosen and the next best option available.
A good example of opportunity cost in the real world would be the decision to take a year out of work to complete an MBA course, which would hopefully result in a better career and salary. By doing this you will lose a whole year’s salary and in making your decision you will need to be sure that the longer-term benefits gained from getting an MBA outweigh the short-term salary loss.
You can use the concept of opportunity cost to help you grow your wealth, simply by looking at the type of asset you are spending your money on and evaluating its money-making potential.
What is an Asset?
Asset – Any item of economic value owned by an individual or corporation, especially that which could be converted to cash – http://www.investorwords.com/273/asset.html
There are four general types of assets:
- Assets that generate regular, direct income – these might be stocks & shares that produce dividends, a buy-to-let property that produces rental income or some sort of intellectual property that has been licensed to other businesses to use.
- Assets that enable you to earn money – as an enabler the asset will not generate direct income, but tends to be the tool which you can use to earn an income, such as a web designers laptop, factory machinery, a tradesman’s tools or even knowledge that you have acquired from years of work experience / academic study.
- Assets that are likely to increase in value – Works of art, antiques, precious metals and property are all examples of assets that have the potential to increase in value, allowing you to profit from a future sale
- Assets that are likely to decrease in value – Just as some assets tend to increase in value over time, others will decrease in value as soon as you have bought them. A classic example is a brand new car which can easily lose 20 – 30% of its value as soon as it leaves the showroom. Consumer electricals such as televisions are also prone to quickly losing value, as newer and better models are introduced onto the market.
Some assets will fit into more than one category. For example a laptop is a key tool for helping you to run a freelance writing business, but it will also decrease in value over a number of years and will eventually need to be replaced at cost. Property tends to increase in value, but unless your are renting out a room or the whole house, you won’t be able to generate regular, direct income.
Asset Management
As we progress through life, we are making constant purchasing decisions. Mostly these are for small, regular purchases such as food shopping or new clothes, but occasionally we need to make bigger spending decisions, such as buying a new car.
By being aware of the types of assets that you are spending your money on, it is possible to maximise the opportunities to grow your wealth.
For instance you may need to buy a car to get you to a new job that you are about to begin. Feeling a bit flush you fancy the look of a brand new BMW which costs £22,000.
From a business point-of-view, spending all your savings on an asset that will loose a significant proportion of its value as soon as it leaves the showroom doesn’t make much sense.
Admittedly the business point-of-view does not take into account the feeling of personal prestige in buying a nice new car, but somebody who is keen to grow their wealth will be more willing to forget the personal-prestige and buy a cheaper alternative, so that they can invest the rest into an ISA.
By taking this approach they will have purchased two different types of asset:
- The car which is likely to decrease in value, but will still provide the practical functionality of getting from A-Z
- The ISA which is likely to increase in value and possibly deliver some future income
What this example shows is that you can’t grow your wealth by spending all your money on assets that decrease in value.
On many occasions buying assets that decrease in value is unavoidable, but by trying to focus your spending on assets that will increase in value, generate an income or enable you to make money, you will be in a much better position to grow your wealth.
