Tuesday, March 25, 2014

Opportunity Costs are Sunk Costs

Opportunity Costs are Sunk Costs
Ever since we paid off our house early, I've had a nagging feeling that we'd done something a little foolish. Like Johnny Moneyseed says, paying off your mortgage early is silly, right? In the timeframe that we did it, from 2010 to 2013, it was downright costly. This handy calculator from dqydj.net shows that we gave up a 17.4% annualized return by not putting our extra mortgage payments into the S&P 500. Because the market went on a tear during those years, the money we put towards the house had significant opportunity costs. Opportunity costs are what you sacrifice when you take one course of action instead of another. Every choice has opportunity costs: you go down one path, and you pass up the chance to go down another. Two roads diverged in the woods, and all that. In this case, we gave up historic gains in the market in order to book a 4.25% gain by paying down the mortgage. And it frustrates me, because who knows when an opportunity like that will come again?

The rub is that there isn't much I can do about it now. We're investing more these days, which is nice. But we can't turn back the clock to 2010 and buy the S&P 500 at 1,100. We're buying at today's prices, and I look back with longing for the bargains of yesteryear. On down days, I kick myself. Since we only started investing in 2008, lost a lot of money, then stopped, and didn't truly get serious about investing until, maybe, 2012, we missed out on the first great buying opportunity of our investing career. And while I know there will be other chances to buy the market on sale, when I sit down and think about our past decisions for too long, I wade through a wave of bad emotions. I feel regret. Like we made a mistake...a five figure mistake. I feel stupid. Then angry...at myself.

A lot of good that does me. Feeling bad about the past doesn't make the present any better, and my money says it doesn't help the future a whole lot, either. Al Pacino said once that guilt is like a bag of bricks: all you got to do is lay it down. Simple enough. But what if you keep picking the bag back up?

An old saw from investing has helped me turn the corner: sunk costs are irrelevant. Sure, it sucks that we've suffered those opportunity costs. But that opportunity, and that money, is gone. And it ain't coming back, either. Our opportunity costs are sunk costs, and are therefore irrelevant. The only thing that matters now is, well, what we decide to do now. If we think leveraging our home and using that money to invest in the market is a good idea, we might decide to tap that equity. (But don't bet on it.) Still, better to focus on what we ought to do today than to wring our hands about what we wish we'd done last year.

Like Lily Tomlin says, forgiveness means giving up all hope of a better past. When I give up trying to improve my past, I can finally get over it. I can accept that missing out on this last rally, and spending like crazy during my twenties, and waiting for so long to finally use my retirement accounts, that's all in the past. It really and truly doesn't matter anymore. And when I get that, I can forgive myself.

So if you have some stuff in your financial history that nags at you, like a few years of reckless credit card spending, or student loans that just didn't pan out, or a great investment you let pass by, I'm hoping you can just lay that stuff down. It's done and gone, and it doesn't matter, anyway, friend. Thanks for reading.


*Photo is from vagawi at Flickr Creative Commons.

69 comments:

  1. Would it help if I told you that you're not alone? We briefly regretting rushing to pay off debt in 2012-2013, since that money would have gone crazy far in the market, but hindsight is 20/20 - not foresight.
    If I'm remembering correctly, one of the first chapters in YMOYL is all about coming to peace with what's in your financial past and letting go of it. Valuable lesson, I think.

    ReplyDelete
    Replies
    1. You know, I've never read that book and really should, Mrs. Pop. I think I have an old copy on the bookshelf, too!

      Sounds like that chapter could help me quite a bit -- thanks for the recommendation.

      Delete
    2. Yes!! It's such an amazing book DBF - you will LOVE it!! I had forgetting the point that Mrs. Pop pointed out, and it's good for all of us to remember, because we each have financial mistakes we wish we could erase. Great post!

      Delete
    3. Thank you, Phoebe! I've got a few recommendations now from bloggers I trust. I really do need to read YMOYL now.

      Delete
    4. You are not alone DB40, I still haven't read it yet either! I must put it on the reserve list from the library.

      Regarding the financial "mistake" of paying off your mortgage early, glad you finally realised to give yourself a break! How many people would love to be in your position right now? Me for one! :)

      Delete
  2. Life is really about winning some, losing some and lessons learned. At least you have nothing to worry about payments for home mortgage anymore. Part of the weight off the guilt bag, I must say.

    ReplyDelete
    Replies
    1. That's true, Jen. Life can't just be a string of wins. And even if there are some big opportunity costs associated with paying off the mortgage, it's not a bad thing to do with our money.

      Delete
  3. I actually started investing money in the market when I graduated college in 2006! Talk about bad timing. I guess the lesson is that you can never time the market and you should only control what you can. At least you have paid down your home and you can contribute more to your retirement and I'm sure there will be another bull market (if this one is done!)

    ReplyDelete
    Replies
    1. You really can't time the market, can you? Had the timing been a few years earlier, say, paying down the mortgage from 2006-2008, we'd feel differently.

      Delete
  4. This is one where I'd have trouble feeling too bad. Let's say you had your mortgage paid of since 2000. Would you have mortgaged your house in say April of 2009 to invest in the stock market? I think not. Cherry picking any short timeframe you will always find some missed opportunities. We paid of our $300k house in 2007 just before the anointing of President Obama. I slept better as our stock and bond investments tanked over the next 2+ years. Having our mortgage paid off allowed us to accelerate investing and we kept putting more money in during the big crash of 08/09. In then end I think we came out ahead because of that buying during the "market sale".

    I guess you always have the option of getting a new and fun mortgage. I wouldn't do it. But it is an option.

    ReplyDelete
    Replies
    1. Good point, Wade. We only had our mortgage from 2010 to 2013, so it just happened to coincide with the market rally. But we can always say, "what if". It just doesn't do us a lot of good.

      We are considering tapping our equity to do some real estate investing, but only if and when we run out of cash. We'll see.

      Delete
  5. I have been trying to let go of some of the things I did. I didn’t pay down a mortgage, but I spent money on useless things that could have gone into the market. Before I fully embraced the personal finance world, there was too much month at the end of the paycheck, and what have I got for all that crap? Just another full garbage bag. Instead of getting those awesome returns, I’m throwing money out. Good money, it was. Mrs PoP mentioned YMOYL, which I love, and I am still working on that part. I think it says, “No blame, no shame.” Well, it’s easier to say than do. Right now, I might be at a point where I need to prove to myself that I can, indeed, be smart with my money. Maybe once I see me actually making good decisions, I can set that bag of guilt down for good.

    ReplyDelete
    Replies
    1. Thanks for sharing that story, Jamie. I think we all have some part of our financial history that we wish we'd been smarter with, or just done things a little differently.

      I really do need to read that book. No blame, no shame is good advice, even beyond our finances.

      Delete
  6. I feel the same way. Since we're looking to buy, we kept a good portion of our money in cash. If we had invested it, we'd me much better off...being that we've been thinking about buying for the last few years but haven't. It's a tough market here. But as you mentioned in a previous post, I think your wife really wanted the peace of mind of not having the mortgage. Remember...a happy wife means a happy life! =)

    ReplyDelete
    Replies
    1. I hear what you mean, Andrew. When we have a property purchase on the horizon, we're kind of forced to put more money into cash than we normally would. But there isn't much of an alternative. There's no way I'd be able to put all that money in the market, and just hope that nothing went wrong in the short time between the investment and the time we'd need the money for a house.

      Your final point is some of the best wisdom a man can ever learn. If momma ain't happy, ain't nobody happy.

      Delete
  7. I actually don't worry at all about the opportunity cost of paying off my mortgage. I worry sometimes about giving up all that liquidity. I haven't given up on any tax-advantaged retirement accounts. I will probably wait until late 2015 to make my Roth IRA contribution for that year, but I will still make it.

    ReplyDelete
    Replies
    1. That's great, Leigh! I love your attitude about your approach. Way better to own the decision than to second guess it, in hindsight. And as long as you're still investing at a good clip, it's a diversified approach: not as either/or as I painted it in the post.

      Delete
  8. Thank you so much for sharing this viewpoint. For whatever reason, it has become popular for frugality / ER blogs to espouse the wisdom of paying off the mortgage. Because the audience trends toward younger, higher earning professionals, I get frustrated by how this advice actually works against reaching ER . Retireby40.org, had a whole cheerleading section behind his plan to pay off a 30 year mortgage super early. Only if you are near to or at retirement, and need to reduce risk (e.g. buy bonds for you desired AA) is this helping. Young people (40 and less) are given a golden opportunity to get a long fixed loan well below historic market return, which is also tax-advantaged and a terrific hedge if inflation turns up. But, in your case hindsight is 20/20, lots of people freaked out in the aftermath of 2008/9 and made much worse decisions than you did. Better to learn these things and fine tune the plan before ditching the day-job.

    ReplyDelete
    Replies
    1. That's true, we could have done much stupider things with our money than put it in the home, post 2008. I think the market crash had a lot to do with how we approached the home, and investing in general. We lost quite a lot in 2008 and were once bitten, twice shy. The 4.25% guaranteed sounded awesome...at the time. Oh well, no big deal now! Today is here, and that's all we can impact.

      Delete
  9. Thanks for this, DB40. Forgiving ourselves for our past spending mistakes is something we work on a lot. I have to say, though, I think paying off your mortgage was a good thing. When we "owe no man", we truly have financial independence. You could play the "what if" game forever, I suppose, but you can't get around the freedom that having no debt brings.

    ReplyDelete
    Replies
    1. Thanks, Laurie! It's hard to put a dollar figure on it, but we really are a lot more relaxed now that our costs are so low. We can rest easy knowing that even if we lost all our income, we'd be able to ride it out for a few years without too much trouble.

      I don't know if this enters the analysis, but it's also given us the guts to finally pull the trigger on some investment property. I can't say whether we'd do the same if we still had a mortgage or not.

      Delete
    2. I'm with Laurie! And love the Lily Tomlin quote. It's beautiful. Owing no one is so huge. And I'm sure (but sad) that there will be more opportunities to join in at a low point in the market again over the years, though it may or may not be so dramatic.

      Delete
  10. There is no feeling in the world that compares to being debt free and owning your home outright.

    HOWEVER.....you are right that there is huge opportunity costs to putting the money into paying 4.5% instead of earning 10% or more. And if you put all your money into paying off the mortgage, and then you need it for something else, you can't access that money for another purpose. (Let's assume your emergency fund isn't maxed out.) My husband and I talk about this all the time and are considering building a new house on which I think we will take out a mortgage, depending on interest rates, for this exact reason. Plus, now, if we paid cash for a new house, we'd have to cash out some investments and pay tax on any gains we had. So in a way, it would be a losing proposition.

    ReplyDelete
    Replies
    1. It's a tough call, Kathy. I agree that the math definitely says to use leverage. I suppose it depends on what the market would do over the life of the loan. For a 30 year loan though, it's a pretty safe bet to say it'll outperform the mortgage.

      Delete
  11. Thanks for this perspective DB40. For me, paying off my mortgage seems like a dream because all I really want is to be debt free (and I mean from evil consumer debt too). I spend a lot of time kicking myself but also trying more and more to pick myself back up and move forwards. I hadn't thought of it like this before re your mortgage payoff. I do think you've achieved so much in such a short space of time when you decided to pay off your mortgage and there will always be other opportunities for investing I'm sure. Keep your chin up!

    ReplyDelete
    Replies
    1. Thanks for the encouragement, Hayley! We really don't have anything to feel bad about, but I'll still beat myself up anyway. It's just part of my personality. Looking back is, at least for me, pretty counterproductive. There's a lot we can be proud of, but I'll manage to focus on the mistakes sometimes.

      Delete
  12. If you torture yourself with the "might have beens", you'll loose sight of where you want to go and how you want to get there. Sunk costs are difficult to handle emotionally for humans for some reason!
    We're still a bit undecided on our mortgage repayment plan, but are leaning towards rounding up a few hundred every month, then investing the rest.

    ReplyDelete
    Replies
    1. It's a dangerous cycle, to be sure, Three is Plenty. (I always want to reply with "Mom", but that sounds weird. :)

      Sunk costs really are a tricky fallacy. We're bad at understanding that past decisions are irrelevant.

      Delete
  13. I've tried to chalk it up to a life lesson, which is definitely aasier for me to say, as I'm in my mid-20s and haven't yet felt the sting of a 5-figure loss from the market. However, I still look back at my graduate school time, when despite actually having enough money to save (I was lucky enough to be on a fellowship) I spent most of that money traveling, drinking, and treating my wife and friends to good times. I wouldn't call it squandered, but had I known what I know now, I'd easily have an extra $20K in the bank. You're absoultely right, Mr. DbF - it's a sunk cost. I can't go back. I am better for it now, and so are you. Also, as many have been quick to point out, you're now free from the shackles of a mortgage, and you can't put a price on peace of mine, friend. If it helped you and Mrs. DbF sleep a little better at night, it's worth every penny of it. We go on into the world wiser. Keep that beautiful chin up, good sir, and remember that you'll still be... Done By Forty.

    ReplyDelete
    Replies
    1. Is it wrong that I'm just happy you think I have a beautiful chin?

      Thanks for the encouragement, buddy. Things really are pretty awesome, if I look at life objectively. So we made a few sub-optimal choices. Oh, well. We'll make better decisions going forward because of them.

      Delete
  14. That's just it with the market, no one knows where it will be in a few months, a year, or even several years. On the other hand, you did know where you could get a guaranteed return of 4.25% on your money. And now that your mortgage is paid off, your cash flow is better, and I bet you and your wife sleep better at night. Reap the gains you made and don't worry about lost opportunities.

    ReplyDelete
    Replies
    1. Oh, that's a great way to look at things, Bryce. Be happy with the gains we have and don't worry about lost opportunities. I might just write that on my computer's background.

      Delete
  15. For me, the choice to pay off my mortgage instead of invest is based on my own motivation. I've lost money in the stock market before so taking the risk is not something that I want to do. On the other hand, I find that I am highly motivated to pay off my mortgage. I have a spreadsheet and I watch the debt go down and think of ways to throw more money at it. My financial freedom timeline is less than 5 years from now so low risk is where I want to be. Past investing mistakes and real estate mistakes are all learning experiences. I just adjust my plan and continue forward.

    ReplyDelete
    Replies
    1. With fewer than 5 years to financial freedom, I don't blame you for avoiding risk, daizy. You basically have the game won: you just need to be conservative, protect the ball, and run out the clock, so to speak.

      I'm going to head over to your blog and pick up some pointers. Congrats on being so close to financial freedom!

      Delete
    2. My blog is a bit unorganized. Maybe that's because my plan keeps changing. I'm one of those 'slash expenses, live in a shed' kind of people although I'm not actually living in a shed...yet. My goal is to be my own benefactor so I can do some sort of artsy-crafty type of business. Life keeps throwing me curve balls though.

      Delete
  16. You may have missed out on some stock market opportunities - but living in a house that is 100% yours has its own value and you can't discount that. You guys are doing AMAZING at saving and investing now, so don't give yourself a hard time about some sunk costs (hindsight is 20/20! It could have easily gone the other way; you just never know in the present). Instead, celebrate the fact that you're killing it now!

    ReplyDelete
    Replies
    1. Yay! Thanks for the pep talk, Kali. You rock, and I appreciate the motivation. There's a lot we can be thankful for with the path we've chosen.

      Delete
  17. Dbf
    Market could have dropped another 40 % when I lost a lot of money I regretted not paying down my mortgages, however today I'm glad I didn't. You're seizing on buying rentals with leverage which will make up for you r misses. Can I take credit for that.

    ReplyDelete
    Replies
    1. Sure you can take credit, Charles! Your mentorship has definitely pushed us to treat leverage as a tool, rather than something to always be avoided.

      Delete
  18. In no way do I believe you need to regret what you've done. Paying off a mortgage is never silly, even if the numbers might suggest so. You've relieved yourself of a huge debt and taken that risk completely off the table. You don't even have to think about it anymore. That's awesome and worth huge piece of mind to me!

    Keep in mind...the market has averaged around 10% return/yr. for it's history. There are plenty of years ahead with great returns and, with the debt gone, you should have more money to throw at it to make up for lost time.

    ReplyDelete
    Replies
    1. Thanks, Brian. It's hard to put a figure on our peace of mind, but it's certainly worth something. Maybe more than the opportunity costs.

      We're definitely trying our best to play catch up now, with our additional cash flow. It's hard to make up for lost time, but all we can do now is all we can do.

      Delete
  19. You thought was right, and that's solid man. If you hadn't paid off your house early, do you think you would have invested it all in the market? If not, then it's not as big of a loss as it seems. I think the freedom that comes from paying off a mortgage early is it's own reward. Not to mention, no one can time the market. You had no way of knowing it would blow up to 1800. If you had invested that money and we had sunk into another recession, you would probably be kicking yourself for that (maybe). Right now, what you do now, is that you can sit in your house and think "I own this sucker," and know that nobody is making money off of your loan anymore. That's rad man, and it's all you.

    ReplyDelete
    Replies
    1. Please forgive my many typos. You did what you thought was right... what you can do now is sit in your house and think... That's what I meant to say there.

      Delete
    2. That's a good point, Ryan: it's not likely at all that we'd put that all that additional money in the market, as we did with the home. I'm sure we were more motivated to be debt free than we'd be, intrinsically, motivated to invest. So the losses aren't quite as dire as they appear at first glance.

      Thanks so much for the encouragement. It's great to hear.

      Delete
  20. I don't think paying off a mortgage is ever silly - debt freedom can never be a bad thing in my eyes - but I know exactly where you're coming from.

    Mortgage v market is our main subject of discussion, but we have no regrets with what we've chosen to do so far. We have perhaps cost ourselves a little money doing it this way, but we both sleep better at night having halved our mortgage debt.

    Having said all that, in January we're changing our tactic and halting the mortgage over payments, basically for the same reason you've highlighted in this post.

    I'd also add that the markets can be scary - paying off debt is not. It's simple and easy to understand and can be the best choice for some people.

    ReplyDelete
    Replies
    1. It's a debate that's hard to settle, because it depends on what the market is going to do in the few years you're considering a mortgage paydown. And since none of us has a crystal ball...

      I think your plan to halt the extra payments is, in some ways, less risky. You can always take your invested dollars and put them towards the mortgage. The reverse is rarely possible.

      Delete
  21. Exactly! It's done and you can't turn the time back. We all make mistakes, we all miss opportunities, that's how life is supposed to happen. The important thing is to keep our chin up and make sure we miss as few opportunities as possible. And at least in your case it's not reckless spending - you managed to completely pay off your mortgage which still is an incredible feat!

    ReplyDelete
    Replies
    1. Thanks for the perspective, C. You're right: it's a case of me making the good be the enemy of the great.

      Delete
  22. I agree with you about the nagging feeling of "Am I doing something wrong?" when paying off the house early. I am just now starting to lean into it. While the math certainly works against the concept of paying it off early, It does reduce risk. And what I like about paying off the house early is that it reduces my cash flow expenses the day the mortgage is paid off in real dollars. Had I invested the money instead, in pretax retirement accounts, that money would not be accessible until retirement. Once the house is paid off you have more options NOW, and can take what was the house payment and invest that. With that being said I am first contributing over 15% to retirement accounts before paying extra on the house.

    ReplyDelete
    Replies
    1. Good point about the additional cash flow benefits, Action Economics (good name, by the way). Having additional cash now (along with lower expenses) is a significant boon. There's some additional risk along the way while you're paying down the mortgage, but if you make it to the finish line, there are benefits.

      I like your approach of investing and considering paying extra on the house. As usual, the prudent approach is sometimes "both" rather than either/or.

      Delete
  23. I once wrote a blog post about how a majority of student loan blog posts are pointless because they focus on avoiding student loans even though 99% of the people reading it likely already have taken on student loan debt and are likely graduated. Some people got really upset and I couldn't figure out why. Talking about strategies for paying down loans is productive but like you said, they are essentially sunk costs in a way - the decision has been made and you can't go and undo the decision. It's better to be forward-looking than always having your eyes on the past.

    ReplyDelete
    Replies
    1. I totally see your point about the student loan advice, DC. Once those costs are realized, advice talking about how you should avoid them isn't of much value. The best advice should hinge on how to deal with the current situation. It's too bad it wasn't received well.

      Delete
  24. It's never too late, you can always re-mortgage the house, and put it in the S&P.

    BUT, I bet you won't do that, because it is risky. Yet, that is the same as you would have done, by not paying it off.

    And I bet you sleep well at night, knowing it s paid off. Open a line of credit, and use it for an outstanding opportunity that may present itself, like a rental.

    I have 4 properties paid off, I would have done the same.

    ReplyDelete
    Replies
    1. That's really impressive! I can only imagine the cashflow from those properties, owned free and clear.

      I doubt we'll be too tempted to tap the equity in our house until we run out of cash for investments. But if we get to that point, it's a possibility.

      Delete
  25. Time will tell if it was a bad decision. Those big S&P gains only exist on paper. It could easily regress to the mean in the next 4 years, and your decision will prove to be pretty sound. The closer you get to retirement, the more you want to focus on reducing expenses.

    Ultimately, you may have made a marginally "less good" decision. Never think of it as a "bad" decision though.

    ReplyDelete
    Replies
    1. Great point about the market gains. It's possible paying off the mortgage won't see as poor a decision if things change.

      Fantastic name, too! I love that.

      Delete
  26. I sometimes find myself paralyzed in my decision making for fear of missed opportunity cost. I think we just have to accept that we're not always going to get the best deal or make the perfect decisions- the anxiety isn't worth it.

    ReplyDelete
    Replies
    1. Fantastic perspective, Stefanie. The very concept of opportunity costs compares reality to the perfect alternative. It's kind of an unrealistic and unfair comparison.

      Delete
  27. Forgive me if my comment repeats - the original disappeared.

    You're always so zen. Nobody could have predicted what the S&P would do back when you had the opportunity to invest. It's a risk. I for one applaud you for investing in the financial security that no other investment can provide - owning your own home outright with no mortgage payments. It's where I would put my money, because we can't predict the stock market or whether we will have a job next year or become disabled in an accident.

    I still carry around regret about my student loans, mainly because I'm still paying those suckers off at 7% interest. But, as you said, it's in the past and I learn from the experience with every payment.

    ReplyDelete
    Replies
    1. Thanks the kind words, Emily! There are definitely some upside to what we did, and I'm not giving that enough credit.

      As for your student loans, those likely have a huge ROI that's hard to calculate, but definitely there. My student loans were some of the best debt I ever had.

      Delete
  28. We also paid off our home in 2013 and do not care the least bit what we may or may not missed out on. My husband has always been a hard worker in good health until that one day when everything turns upside down. Not worrying about a mortgage is much more comforting than thinking what money did I miss out in the stock market.

    ReplyDelete
    Replies
    1. Congrats on paying off your home! Your perspective shows a healthy respect for situations that can change dramatically.

      Delete
  29. I feel yah... greed and fear is always there.

    I've been losing money in a stock recently in my IRA and I've been thinking how much better it would have been to just use the proceeds to pay off debt.

    People are going a little crazy now since the stock markets are doing so well. As soon as they start losing money, they'll remember the balance again!

    I think when my CD tranches come due I'm going to pay off my rental property at a 3.35% mortgage rate in one swoop. I don't care. I want to simplify.

    Sam

    ReplyDelete
  30. Man, I wish I'd considered the value of that in the post. Simplicity is something that's worth a lot; maybe enough to justify some opportunity costs. With what CDs are paying when they come up now, it might be a really savvy move.

    ReplyDelete
  31. Don't be so hard on yourself! The market could've easily tanked and you would've felt like a genius =)

    ReplyDelete
    Replies
    1. Thanks, Holly! I'd have been poorer, but I'd have felt smarter. Tough to say whether I'd have been happier or not. :)

      Delete
  32. It's all hindsight now, but I wouldn't feel so bad... Paying down debt and having a home you own FREE and CLEAR is a place most people in our society will never get to. The alternative could be much worse, my friend! ;)

    Leverage can be a great tool, but it can be dangerous as well... I know I have to watch things very carefully since my entire early FI plan involves the use of excessive leverage...

    But what goes up always comes back down. There will be more buying opportunities in the future.

    You're doing amazing!

    ReplyDelete
    Replies
    1. Thanks for the perspective, FI Fighter. I know some good opportunities will come again, and we should be ready to capitalize. :)

      Delete
  33. I just found out about this article by reading today's post. It is interesting that the same type of action can appear reasonable, but have starkly different outcomes.

    For example, in your case it was costly in terms of future net worth that you paid off the house in 2010 - 2012.

    However, if you paid off that house in another period such as 2006 - 2007 or 1998 - 2000 the results and outcomes may have been different.

    Unfortunately, noone knew in 2010 - 2012 how great stocks would have done. We don't know that you would have put all the money to work in VTI - you may have gone international. Of course, not all stocks did so well - international and emerging markets haven't done so nicely since 2010.

    ReplyDelete