7. Allocate Capital By Opportunity Cost

Should you pay off your debt or invest? Buy government bonds or common stock? Go with a fixed rate or interest-only mortgage? The answer to financial questions such as these should always be made based upon your expected opportunity cost.

In its simplest form, opportunity cost investing means looking at every potential use of cash and comparing it to the one that offers you the highest risk-adjusted return.

 It's about evaluating alternatives.  Here's an example: Imagine your family owns a chain of successful craft stores.  You are growing sales and profits at 30% as you expand across the country.  It wouldn't make a lot of sense to buy real estate properties with 4% cap rates in San Francisco for the sake of diversifying your passive income.  You'll end up far poorer than you otherwise would have been.  Rather, you should consider opening another location, adding additional cash flow to your family treasury from doing what you know how to do best.

You notice that I use the qualifier risk-adjusted returns.  In the context of opportunity cost investing, this is extremely important.  You cannot just look at the sticker rate and come to a conclusion, you have to figure out the potential downsides, probabilities, and other relevant factors.  An illustration might help.  Picture yourself as a successful doctor.  You and your wife have $150,000 in student loan debt at 5%.  In this case, it doesn't matter if you can earn 10% by investing that money, it might be wiser to pay off the liabilities.

 Why?  The bankruptcy code in the United States treats student loan debt as an especially poisonous type of liability.  It can be nearly impossible to discharge.  If you fall behind on your bills, the late fees and interest rates can spiral out of control, depending upon the type of student loan.  You can have your Social Security checks garnished during retirement.  It's far more vicious, in many cases, than things like mortgages or even credit card debt.  Even though it might seem foolish on a first-glance basis, it is the wiser course of action to eliminate the potential landmine during moments of prosperity.

Even if you follow the (in my professional opinion, wise) practice of regularly buying index funds through a dollar cost averaging, the concept of opportunity cost matters to you.  Unless you are more prosperous than the median family, you probably won't have enough disposable income to maximize all of your retirement contribution limits.  This means you have to look at your available options and prioritize where your money goes first, to make sure you get the most bang for your buck.

Let's say you work for a company with 100% matching on the first 3% of income through the 401(k) plan.  Your salary is $50,000 per year.  In this case, many financial planners are going to tell you the smartest thing to do (assuming you are debt-free) would be:

1. Fund the 401(k) up to the 3% matching threshold to get the most free money you can.  In this case, it would be $1,500.  You'd get $1,500 in matched funds, providing an instant risk-free doubling of your money.
2. Fund a Roth IRA up to the maximum allowed contribution limit for both you and your spouse.  They are better than Traditional IRAs in many cases.
3. Build a 6-month emergency fund in a highly liquid, FDIC insured savings account that you don't use otherwise.
4. Go back and fund your 401(k) up to the remaining contribution limit.  Even though you won't get any more matching money, you'll be able to take a fairly large tax deduction and the money will grow tax-free within the account until you retire or take it out of the protective confines of the tax shelter.
5. Buy index funds, blue chip stocks, bonds, or other assets through taxable brokerage accounts and / or acquire real estate for the rental income depending upon your preferences, skills, risk profile, and resources.

By adhering to a plan like this, you make sure money gets allocated to the most advantageous uses first, providing the most utility for you and your family if you run out of cash to save before reaching the bottom of the list.