Opportunity cost and your retirement
One of the issues that many of us forget about when it comes to saving for retirement is opportunity cost.
Opportunity cost is the money lost when you don’t take advantage of what’s available to you. When it comes to retirement, one of the most common ways opportunity cost makes itself manifest is when you take money out of your tax-advantaged account.
More than just the capital
When you consider opportunity cost, you have to go beyond the capital that you pull out of your tax-advantaged account (RRSP, TFSA). You also have to look at the money that capital would have earned had you left it in place. A future value calculation can give you a pretty good idea of the difference between what you could have ended up with had you left your money in your account.
The reason is mattered so much is due to compound interest. Compound interest is the money you earn on your earnings. With compound interest, the amount you earn through investing is added to your original principal. As time goes on, your portfolio grows because your earnings start to earn interest as well. It leads to faster growth in your portfolio.
If you take a few minutes to calculate compound interest, you can see that it has a huge impact on your overall portfolio performance.
One of the keys to building your nest egg is consistency over time. Few of us have a large lump sum that we can use to make one big investment to let sit. Instead, it’s possible to use dollar-cost averaging to your advantage, putting what you can into an account on a regular basis.
Use a tax-advantaged account, and you can get special treatment for your money, letting it grow tax-deferred (RRSP) or tax-free (TFSA). This increases the effectiveness of your investment dollar, helping it grow even faster.
It’s true that you can replace the money that you withdraw from your account back into it. However, the replacement of the money doesn’t make up for the lost time. You can’t get the time you lost, where that capital could have been earning money. That is where the opportunity cost comes in. When you lose that opportunity, it’s gone, and it’s much harder to catch up later on.
Due to the power of compound interest, it makes sense to start as early as possible. Even if you don’t feel like you have a lot of money you can invest in a tax-advantaged account, get started anyway. Investing a smaller amount of money for a long period of time can be more productive than investing a larger chunk for a short period of time. The long time frame used in regular, dollar cost averaging allows time to do its work with compound interest and gives your portfolio time to recover from market setbacks.
With a little planning and consistency, it’s possible for you to build a nest egg that allows you to enjoy your retirement.
I made the mistake of taking money out of my RRSP a few years ago thinking I would regain the contribution room the following year. That is not the case. You can take money out of a TFSA and regain the contribution room the following year, but once you take money out of an RRSP you have lost that contribution room forever. This was a costly error for me.