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Learning, Sharing, and Teaching => Ask a Mustachian => Topic started by: Jadambomb on June 20, 2018, 10:44:20 AM

Title: Should I Use 4% or 7% for Opportunity Cost?
Post by: Jadambomb on June 20, 2018, 10:44:20 AM
When calculating opportunity cost, do you use 7% (assumed growth rate of investments before inflation) or 4% (assumed growth rate after inflation, because this is what you actually can pull out in any given year)?

This has always been confusing to me.

Thoughts?
Title: Re: Should I Use 4% or 7% for Opportunity Cost?
Post by: Grif on June 23, 2018, 12:53:05 PM
As far as I know, 7% actually is an inflation adjusted figure for overall market returns. Without inflation its nominally 10% per year. 7% is what MMM and most people use as an opportunity cost for their money when making calculations. Part of those calculations are that you invest that money and leave it alone year after year. The 4% rule comes into effect when you start taking withdrawals. Theoretically, if returns are 7%, why can’t we withdraw 7%? Well because if the market is down and you make withdrawals you are locking in losses each year that the market is down. It turns out 4% is low enough that even though you locked in a lot of losses in the down years, the gains on your reduced nest egg in the good years are good enough to sustain 4%. But in terms of opportunity cost calculations, pretty much everyone uses 7%.
Title: Re: Should I Use 4% or 7% for Opportunity Cost?
Post by: maizefolk on June 23, 2018, 01:21:01 PM
Yup, over the super long term the markets grow at ~6.8% after inflation. The problem for SWR math is sequence of returns risk.

For calculating opportunity cost it depends a little on what you're evaluating and whether the value of future items are given in current dollars or future dollars whether you want to incorporate inflation into your calculations.
Title: Re: Should I Use 4% or 7% for Opportunity Cost?
Post by: boarder42 on June 24, 2018, 10:20:52 AM
Most here you 6-7% post inflation dollars. But it greatly depends on what you're calculating against. If it's a mortgage you should use pre inflation rates of 10-11% to compare to your mortgage rate since a mortgage doesn't index with inflation. That or drop your mortgage rate by inflation