Making Financial Decisions | Identifying & Evaluating Alternative Courses of Action

making financial decisions

Making financial decisions requires making choices among alternative courses of action. How you make these choices will affect the outcome of your financial wellbeing. If you make poor choices, you will get poor results. On the other hand, if you make smart and informative choices, you will reap good and fulfilling results.

Considering Alternative Courses of Action

Has it ever occurred to you that after spending money on something, do you realize there is another pressing and important financial need (that you ignored) that required money in the first place? For example, suppose you receive an end year bonus at your work place. Immediately you think how great the Christmas holiday will be with the bonus. You forget to identify alternative uses of the windfall, such as your child’s next term tuition fees. Come next year, you are running up and down looking for credit sources. Had you first considered the alternative uses of that bonus, may be you could have considered setting aside some cash for your child’s tuition fees and avoid adding more debt in your life.

Due to scarcity of resources, you will always be faced with task of identifying and evaluating the best alternatives. This process is crucial for making smart financial decisions. If you have a number of financial needs that, say each needs Ksh. 50,000.00 and you actually have 50K in your account. That 50K can only be available to one need. Once you decide to use it on one, you close its use on the others. Hence, you need to make sure the decision you make to spend the cash on a chosen alternative, among the available alternatives, is the best.

When considering making financial decisions, ask yourself these two questions:

  1. What alternative choices are there?
  2. Which is the best of these alternatives?

1. Considering Alternatives

Your first step in making wise financial decisions is to consider alternative opportunities (other things that you could do with your money.

Considering alternatives is necessary when:

  • You have a financial situation that needs to be expanded, changed or a new course of action to be taken.
  • Faced with more than one need that require the limited available resource i.e. money.

2. Evaluating Alternatives

The purpose of evaluating alternatives is to identify the best alternative among the available alternatives. This is crucial because you always give up something of value when you make choices. That which you give up when you make a choice is known as Opportunity Cost or Trade-Off. It is the cost of passing up the next best choice when making a decision. It represents what someone must give up in order to attain something else. This trade-off may have a significant value even though it may not have a specific monetary value.

Often, opportunity costs are overlooked when making financial decisions. You incur opportunity costs with every decision you make. So, when evaluating alternatives:

  • Compare the benefits of an alternative and its opportunity cost.
  • If the benefit is less than the opportunity cost, pass that option.
  • If the benefit is more than the opportunity cost, consider that option.

When evaluating opportunity cost of your best alternative, the choice is not among several alternatives but only between two mutually exclusive alternatives. However, in case of more than two mutually exclusive alternatives, the opportunity cost is the value of just one alternative and not the rest of them as only one alternative, the next best, is considered for calculating opportunity cost.

It’s important also to note that an alternative is only an opportunity cost if it is a realistic option at that time. If it is not a possible option, then it’s not an opportunity cost.

Let’s now look at some examples of opportunity cost:

Example #1:

Suppose you have Ksh. 15,000.00 to spend. Looking at your current financial situation, you identify three needs that could make use of that Ksh 15K:

  1. Buy a new smart phone
  2. Pay off some money you owe a friend
  3. Pay insurance premiums (life, health and education policies) due end month

Now, you have to make a choice on the best alternative among the three. What are the benefits and costs of these alternatives?

1. Buying a Smart Phone:

The new smart phone you want to buy costs around Ksh. 15K. Currently you have a phone. So, what are the benefits of having the new smart phone at this moment? Nothing concrete! Just an excitement of having a smart phone.

2. Repaying Personal Debt:

You owe your friend Ksh. 15K. You had promised to refund him by end month. Keeping your promise is good because it will keep you in good standing with your friend. You can be sure he will sort you out next time you ask him for a soft loan.

3. Paying Insurance Premiums:

The total insurance premium due next month is Ksh. 15K. Paying your premiums in time is good because it keeps your policies active, you remain under cover and you have peace of mind knowing you are on top of things.

After evaluating your available alternatives, you eliminate the alternative 1 (buying a smart phone) and you remain with alternative 2 and 3.

Now you have the option of either paying what you owe your friend or pay insurance premiums. If you go ahead and pay back the money you owe your friend, you do so by giving up on the opportunity of repaying your insurance premiums and, hence, in this case your opportunity cost would be paying insurance premiums. However, if you opt to pay insurance premiums, you do so by giving up on the opportunity of paying what you owe your friend and, hence, here your opportunity cost is paying back what you owe your friend.

Example #2:

You have stocks worth Ksh. 350,000.00. For a couple of days, your stock price has been on a decline and you are thinking of off-loading them from the stock market. However, financial experts are saying your particular stock will rebound and the price will start going up within the next 6 months. Now, you have the option of either selling them for Ksh. 350,000.0 at present price or to wait for 6 months by which time the prices are expected to go further up. Since you are pessimistic of what the financial experts are predicting, you decide to sell them today for Ksh. 350,000.00 because you are of the opinion that if the stock prices don’t rise up as expected then you might incur a loss. So, by giving up on the opportunity to sell your Ksh. 350K worth of stocks in future for a price higher than Ksh. 350K, you are incurring an opportunity cost, the value of which would be decided 6 months later. Therefore, your opportunity cost is the future price of your stocks which may be more or less than Ksh. 350K.

As you can see from this opportunity cost example, the next best alternative does not need to be in the same time frame as the selected alternative.

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See more practical examples of opportunity cost. (Coming Soon)

Opportunity cost and the time value of money. (Coming Soon)