Let’s suppose you are thinking about quitting your job and starting your own business. The explicit costs of the new business are self-evident: any startup capital required for equipment, employees, legal costs, etc. If you need a loan, you have to add the explicit cost of interest payments (called the cost of capital). But there are also implicit costs, such as the wages and other benefits you would be giving up from your current job and the fact that the startup capital you provide could also be used for alternative investments (such as the stock market). Additionally, there are nonfinancial implicit costs (or benefits) to weigh, such as the impact on your family and personal fulfillment.
Your opportunity cost for starting this business is defined as the sum of all the explicit and implicit costs, based on an alternative future where you stayed at your job, continued earning your salary, and allocated what would have been your startup capital to other investments. What would your return be on path A versus on path B?
Opportunity cost extends to everyday decision making, such as when you drive farther to go to the “cheap” gas station. Suppose you can save 10 cents per gallon on a 20-gallon tank for a maximum savings of only $2.00. Even if this trip is an extra six minutes, you are essentially valuing your time at about $20 per hour, and this doesn’t even account for the gas used in making the longer trip, the fact that you are saving less if your tank is not completely empty, or the mental overhead cost to fit a longer trip into your schedule. Of course, it may feel good to pay low prices or get a discount, but not when you need to spend a considerable amount of your limited time to do so. Time is money!
In business, opportunity cost is sometimes formalized as the opportunity cost of capital, the return you’d get on the best alternative use of that capital, your second-best opportunity. For example, suppose you’re now running your business and you are returning 5 percent to the bottom line for every dollar you spend on an ongoing advertising campaign. You’re now deciding the best way to reinvest some of these profits back into the business.
Whatever you select, you ought to be sure that you are making back at least 5 percent on your investment, because you could easily make that amount by investing more into the ad campaign. Thinking in terms of opportunity cost of capital pits your investment options against each other. Thus, you can make an informed choice among the array of projects and opportunities available to you.
Similarly, in negotiations there is another application of opportunity cost called BATNA, which stands for best alternative to a negotiated agreement. If you have a job offer, your BATNA is the best alternative job offer you have in hand, including your current job. You shouldn’t accept an offer worse than your BATNA, because you can always take this better alternative offer (which could be the status quo).
In less clear-cut situations, it can be more challenging to understand your BATNA, and so it helps to brainstorm and literally list out all of your alternatives. This process can help you uncover additional alternatives that aren’t immediately apparent. In any case, going into a negotiation knowing your BATNA is critical to making a decision that you won’t regret.
Life and business can be thought of as just a series of such choices. These opportunity-cost models will help you consistently make better choices about what to work on, where to live, and whom to partner with. Generally, you want to choose things that have higher value than their opportunity costs, the best of all the alternatives in front of you. When put like that, it sounds simple, right?
Complications arise when you realize that you can’t have it all. There are always trade-offs when you choose among the pursuits important to you.
We’ve tried to explain this concept to our kids in a simple way. Unfortunately, we have little to show for it so far. For our boys, there are only four to five hours from the time they get off the school bus until lights out at bedtime. During this time there are a few essential activities that need to happen, including homework, dinner, and nighttime routines.
They are often disappointed that there is little time left for stories, cuddles, or iPad after they take forever putting on pajamas and brushing their teeth because they are fooling around. We explain to them that the cost of fooling around is that they miss out on these other opportunities. It’s a choice they are making. Similarly, if we go for a special trip out to dinner or ice cream, they lament the lack of time for free play before bed, not fully recognizing the trade-off. One day . . .
Pick Two
GETTING MORE BANG FOR YOUR BUCK
The lever is a simple machine consisting of a bar that sits atop a fulcrum. Through the placement of the fulcrum, the lever amplifies a small force over a large distance to create a much larger force over a small distance. Think of how you might use a crowbar to open a locked door. Back in the third century B.C., Archimedes famously boasted of the powers of the lever, “Give me a place to stand and I shall move the Earth.”
The mechanical advantage gained by a lever, also known as leverage, serves as the basis of a mental model applicable across a wide variety of situations. The concept can be useful in any situation where applying force or effort in a particular area can produce outsized results, relative to similar applications of force or effort elsewhere.
In finance, leverage refers to borrowing money to purchase assets, which allows gains and losses to be multiplied. In this context, leveraging up means increasing debt, while deleveraging is the opposite. A leveraged buyout takes place when one company buys out another, partially using other people’s money.
Leverage
In all these financial situations, the small force is the amount of money you initially put up, allowing you to wield a much larger force through the greater sum of money you have available via the debt you take on. For example, individuals usually purchase homes with down payments much smaller than the total price. In the United States this is typically 20 percent, but in the run-up to the 2007/2008 financial crisis, people bought houses with as little as zero percent down! But by taking on debt, people get to live in the homes they want.
In negotiation, leverage refers to the power one side has over another. If you have the ability to give or take more things than the other party, you have more leverage. No matter what the circumstances, small amounts of leverage can have large effects.
As applied to individuals, certain activities or actions have much greater leverage than others, and spending time or money on these high-leverage activities will produce the greatest effects. Therefore, you should take time to continually identify high-leverage activities. It’s getting more bang for your buck.
You can apply this model in all areas of your life. The highest-leverage choice might not be the best fit every time, but the option that provides the most impact at the lowest cost always warrants consideration.
Which job will give you the best opportunity to advance your career?
Which home renovations might most increase the value of your home in an upcoming sale or most increase its livability?
Which activities will most help your kids in the future, or bring them the most joy?
To which causes or charities would your cash contributions make the most difference (a mental model itself called effective altruism)?
How much and what type of exercise do you need to do to get the most benefits in the least amount of time?
Thinking about leverage helps you factor opportunity cost into your decision making. As a rule, the highest leverage activities have the lowest opportunity cost.
The Pareto principle can help you find high-leverage activities. It states that in many situations, 80 percent of the results come from approximately 20 percent of the effort. Addressing this 20 percent is therefore a high-leverage activity. This principle originated from observations in the late 1800s by economist Vilfredo Pareto detailed in his book Manuel d’economie politique: that 80 percent of the peas harvested in his garden came from only 20 percent of the pods, 80 percent of the land in Italy at the time was owned by 20 percent of the peo
ple, and so on.
Modern-day examples of this principle are easy to find. In the United States, about 80 percent of healthcare spending comes from 20 percent of the patients (see the figure below). Similarly, in 2007, 85 percent of U.S. wealth was owned by 20 percent of the people. While every relationship is not always 80/20, there is a common pattern for outcomes to be far from evenly distributed.
This particular 80/20 arrangement of outcomes is known as a power law distribution, where relatively few occurrences account for a significantly outsized proportion of the total. (It is named after mathematical exponentiation, aka power, because the math that creates the distribution involves this operation.)
U.S. Health Spending Concentration
In the figure above, we see a power law distribution at work in the people who spend the most on healthcare. Other examples with similar patterns include the returns from venture capital, the strength of volcanic eruptions, and the size of power outages. When you’re working to influence such a distribution, you’re often looking toward those top outcomes, as they will have the most impact on the total.
Management consultant Joseph Juran popularized the Pareto principle in the 1940s, advising that the high-leverage plan is to find and focus on the smallest amount of the work that will bring about the best results. He called these high-leverage activities “the vital few.” For example, if you want to improve the effectiveness of a web page, focus on the headline and leading image, often referred to as the “hero section.” This is the first thing visitors will see, and the only thing many of them will read. The hero section is also what will be shared on social media. Small changes to this section—use of a catchier turn of phrase or a more engaging image—are simple, but have potential for a large effect.
The same principle applies to whole organizations. If you are trying to reduce costs and 80 percent of the budget is from 20 percent of the items, it makes sense to spend time seeing what you can do to make reductions in that 20 percent (as in our previous discussion of the U.S. budget). Similarly, if 80 percent of your company’s sales come from 20 percent of its customers, you need to make sure these customers are satisfied, and find more like them. And if 80 percent of the usage of your website comes from 20 percent of the features, focus on those features. Incidentally, these are also the class of features that should go into an MVP (see Chapter 1).
After you determine the 80/20 and address the low-hanging fruit, each additional hour of work will unfortunately produce less and less impactful results. In economics, this model is called the law of diminishing returns. It is the tendency for continued effort to diminish in effectiveness after a certain level of result has been achieved.
When Lauren was at GlaxoSmithKline, an external group was hired to evaluate the quality of clinical study reports and how efficiently they were written. The group evaluated report drafts to see how they evolved over time. For one report that had six drafts, the consultants found that the report’s quality did not substantially improve from draft two to draft six—quite clearly a case of diminishing returns! The team obviously wasted time when making drafts three through six. Also, they placed undue pressure on colleagues who were waiting for the final report.
There is a similar concept called the law of diminishing utility, which says that the value, or utility, of consuming an additional item is usually, after a certain point, less than the value of the previous one consumed. Consider the difference between the enjoyment you receive from eating one donut versus eating a second or third donut. By the time you get to a sixth donut, you may no longer get any enjoyment out of it, and you might even start getting sick.
When continuing beyond a point like this can actually make things worse, you move from diminishing returns to negative returns. This can happen when you are striving for perfection and it becomes counterproductive. There are lots of phrases related to this concept—overdoing it, trying too hard, etc. (see the Too Much of a Good Thing section in Chapter 2).
Law of Diminishing Returns
Overdoing it is also a quick path toward burnout, where high stress can take its toll and eventually extinguish your motivation, or worse. In the late 1970s in Japan the term karoshi was coined to describe the increasing number of people, some as young as their twenties and thirties, dying from strokes and heart attacks attributed to overwork.
Similar negative returns and burnout are prevalent in the high-stress environment of modern life throughout the world. In the quest for athletic success, for example, children all over the United States are suffering extreme injuries from overtraining—a clear sign of negative returns. Parents have started to sign their kids up for specialized coaching programs and commit them to playing one sport year-round at very young ages, which can easily result in overtaxing their young, growing bodies.
In baseball alone, hundreds of young pitchers each year are now having surgery on their elbows, colloquially named Tommy John surgery after the major league pitcher. This is a type of surgery that just a few decades ago was performed only on professional pitchers. Throwing more pitches in a year greatly increases your risk of injury, and so a heavy year-round schedule puts many teenagers in a dangerous situation. A lot of these kids are not even playing baseball two years later, whether it’s because they never fully recovered or they just got completely burned out.
Another familiar example of negative returns is pulling an all-nighter. It is proven that cramming is not an effective method to retain material long term. All-night cram sessions can additionally be counterproductive because no one is at their best in a sleep-deprived state. If the all-nighter is to complete a paper, can the writer accurately evaluate the quality of the writing in the middle of the night? Probably not. Thus, the paper deteriorates as the night progresses.
So, once you’ve pushed through the highest-leverage pieces of a given project, when should you move on? Clearly, you ought to quit before you hit negative returns, but just because you’ve hit diminishing returns doesn’t always mean you must stop what you’re doing. It really comes down to opportunity cost. If you can identify another activity that can produce greater results for the same amount of effort, then you should jump to it.
Otherwise, you should keep at your current activity, since you’re still making progress (even if it is slower progress) and you don’t have anything better to do. However—and this is key—you should not assume there isn’t anything better to do. You must periodically brainstorm and seek alternatives, making sure there aren’t other high-leverage projects, with their own 80/20s, just out of view.
GET OUT OF YOUR OWN WAY
Applying leverage and related mental models will help you spend time on the right activities. The next step is getting those activities done in a timely manner. The path to doing this is fraught with traps. The first trap: procrastination.
Our kids are expert procrastinators, and if this is a genetically transferred trait, Lauren must take responsibility. Around the time we first met in 1999, Gabriel wrote an article in The Tech, MIT’s student newspaper, recommending that everyone stop procrastinating. While Lauren was not an expert procrastinator, she typically finished Friday’s problem sets sometime late Thursday night. Gabriel was the only person Lauren knew at MIT who finished his weekly work by Tuesday; in fact, he procrastinated so little that he finished MIT in three years.
One reason why people procrastinate so much is present bias, which is the tendency to overvalue near-term rewards in the present over making incremental progress on long-term goals (see short-termism in Chapter 2). It’s really easy to find reasons on any given day to skip going to the gym (too much work, bad sleep, feeling sick/sore, etc.), but if you do this too often, you’ll never reach your long-term fitness goals.
Everyone discounts the future as compared with the present to some degree. For instance, given a choice between getting $100 today and $100 in a year, most everyone would choose to get it today. Suppose, though, you’re offered $100 in a year, but you can pay a fee to get the $100 t
oday (minus the fee). How much would you be willing to pay? Would you pay $20 to get the $100 right now (netting $80) versus getting $100 in a year?
When you cast this fee as a percentage, it effectively becomes an “interest rate,” called the discount rate (in the example above, it would be 25 percent, since $80 × 125% = $100). Like any interest rate, it can compound, but instead of compounding positively as we discussed earlier, the discount rate compounds negatively. This negative compounding discounts payments out into the future more and more, since you won’t be able to access them until much later.
The discount rate is the cornerstone of the discounted cash flow method of valuing assets, investments, and offers. This model can help you properly determine the worth of arrangements that involve future payments, such as investment properties, stocks, and bonds. For example, let’s say you win the lottery and are offered a choice between getting one million dollars each year, forever, or a lump-sum payment today. How high does that lump-sum payment need to be before you will accept it? You might think initially it should be exceptionally high because the payments go out forever; but because of the compounding discount rate, the expected earnings far in the future aren’t actually worth that much to you today.
At the discount rate of 5 percent per year, for example, the million dollars in cash flow from next year would be discounted to only $952,381 of value today ($1M/1.05). Two years out, because of compounding, the million that year becomes just $907,029 of value today ($1M/1.052). This continues with earnings further out being discounted more and more until they get discounted closer and closer to zero in today’s dollars. Fifty years out, at the 5 percent discount rate, the million dollars that year is worth only $87,204 to you today ($1M/1.0550).
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