Opportunity Cost: What it Means to You
Opportunity cost is defined as the potential benefit an investor misses out on when choosing one alternative over another. Every investor can likely think of an example of something that they once owned and sold at the wrong time or planned to buy and chose not to do so. Some of those examples can be quite frustrating in hindsight. However, in some cases, even what seems like the wrong decision may have still been the correct decision.
It’s never a good idea to make investment decisions based on where you were, rather than making decisions based on where you are. In financial planning investors are routinely faced with these decisions, even if you are not an active trader. Such examples can be something as simple as choosing to buy a car in cash versus financing a car purchase. Or, possibly whether or not you should pay off your mortgage or not.
Imagine a situation in which you had an investment portfolio of $200k that was averaging 7% annually. Simultaneously, you have a large cash position in the bank of $100k earning just 0.50%, with a mortgage balance on your home of $100k in which you are paying 3.5% interest. Simple math would tell us that you are better off investing that money at a 7% average return than keeping it in the bank or paying off the loan. However, depending on your personal situation, there may be more than one correct answer.
As an example, imagine you are closing in on retirement or already retired and by nature are very conservative. A portfolio that is averaging 7% annually is not necessarily going to guarantee such a return every year. It is a reasonable long-term assumption, but in the short term can be negative for several years. Committing capital to a portfolio may not be worth the volatility to you, particularly if the lack of a cash position will drive you to panic in the face of market volatility and sell your investments at an inopportune time.
So perhaps you should pay off the mortgage and save the extra 3%, which is the difference between the interest rate on the loan and the savings account rate. Well, this doesn’t always make sense either. Every investor should have an emergency fund of 6 months to 1 year of cash to fund their lifestyle. Without such liquidity, if you pay off your loan you won’t have the liquidity to address an emergency, and you may have to resort to selling assets such as your brokerage account that was averaging 7%. The unwritten rule of “Murphy’s Law” tells us that emergencies tend to come at inopportune times, and you may be selling investments at a low point in financial markets. Another possible issue is you may be forced to pay capital gains tax at an inopportune time.
Additionally, depending on how far into the mortgage you are, it may not make sense to pay it off. If you are 25 years into a 30-year loan, even though your interest rate is 3.5%, most of that interest was paid in the beginning, and you are now paying primarily principal. Paying off the loan at that point may not amount to much of a savings at all. Sometimes keeping cash on hand is the correct decision.
Even if your portfolio continues to earn very good returns, it doesn’t mean the correct decision is to commit all of your capital there. Investors have no control over, nor can they accurately predict short-term volatility with any degree of certainty on a consistent basis. Neither can the best of investment professionals. While the “would have, could have, should have” feeling may rest in the pit of your stomach, you may still have made the correct prudent decision.
Similar examples can made in terms of portfolio allocation. While a well-diversified portfolio is the prudent decision to fund your future as well as current retirement goals, we can all think of that example of a stock that you believed in, or just had a feeling about that could have made you an extraordinary amount of money. However, investors tend to remember the opportunity cost they missed that would have worked out well. That is where your regret comes from. We tend to forget the ideas we had and didn’t act on that would have ended catastrophically. Sometimes it’s the moves you didn’t make that are the best decisions you’ve made.
Financial planning is about having a strategic approach to achieving a set of goals that will take you from point A to point B with the least amount of risk that is necessary. This means that in the end, the correct decision isn’t always the one that yields the best outcome. The correct decision is the one with the most likely outcome of accomplishing your goals.