A Phrase Every Investor Must Grasp – Opportunity Cost

By: Tim Bennett
Tim Bennett explains why investors must factor in the full cost of every decision they take and the potential cost of not doing so.

A phrase every investor must grasp – opportunity cost

As investors we tend to focus on and justify the decisions we make. Unfortunately we often don’t give due consideration to reviewing the alternatives. This matters, because to properly assess a choice, we need to ensure we have factored in the cost of not taking an alternative decision – this is known as its opportunity cost. This is all about asking the question – what else could we have done with our time, or money, or both?

Two examples

The opportunity cost of taking a degree
Let’s say someone asks us to weigh up the cost of going to University. Most people will immediately start to think about the cost of tuition and living. Nothing wrong with that. However, what about the cost of investing three or four years of time that could be spent working to build up skills and earn a wage? This is the opportunity cost of taking a degree. Admittedly, this cost may well be offset by the potential to earn a higher salary as a graduate but it is nonetheless an important part of any cost/benefit analysis.
The opportunity cost of cash
Alternatively, what about the cost of keeping you money “safe” in a cash account? The obvious benefits of doing so are that you probably won’t lose any of your deposit and you should be able to earn a bit of interest on it. However, what about the lost income and growth you might be able to enjoy elsewhere, perhaps from shares? In the short-term this may not amount to much – and not enough to offset the potential risk – but if you leave your money in cash for years this opportunity cost could be significant. Worse, the real value of your cash will probably be eroded as inflation eats away at its purchasing power – in that context, as a long-term store of value, cash isn’t really very safe.
No-one can guarantee that shares will deliver positive returns, nor that your capital won’t be eroded should the market drop sharply in the short-term. However, historically the gap between the return available from shares over longer periods and that from cash is pretty stark;

An investing framework

It can nonetheless be hard to know where to allocate capital so as to generate the best overall return and minimise opportunity costs. Here is an outline framework that I refer to in other articles as a starting point;.
This slide is saying that the bulk of your long-term savings should be in equities, subject to your ability to follow some of the core equity investing rules. These include never panic-selling when the market takes a sharp dip, (something it has done regularly in the past) and avoiding forced sales to meet a known commitment (or milestone) such as school fees or buying a second car. This latter point requires some sensible asset allocation so that you have sufficient cash reserves on an ongoing basis. It all sounds simple enough but getting this right and correctly balancing liquidity needs against long-term returns requires some careful thought and regular monitoring.
To find out more about how this approach might help you, please contact an Investment Manager.