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What is Opportunity cost?
Opportunity cost is the analysis of the trade-off between one choice and another. Every choice you make in life involves an opportunity cost.
Opportunity cost usually refers to economic consequences, but there are also non-financial factors to consider when making investment decisions.
What Opportunity Cost is Not: Sunk Cost
A common error in assessing options is falling for the Sunk Cost fallacy. This is the tendency for people to irrationally consider the non-refundable time, money or resources already sunk into one choice when deciding whether to continue with that choice or change to another option.
Going forward, if being logical, time, money or effort already spent on one choice is irrelevant to which choice will provide a better financial outcome.
Cost Changes Over Time
Opportunity costs change over time as different options arise, and the cost of each option changes. For example, a change in interest rates would alter your opportunity cost of investing in property vs shares.
What’s more, costs and returns are, by necessity, based on assumptions. These may turn out to be inaccurate. If you assume that every property in Australia doubles every 10 years, and your investment property actually goes down in value, your opportunity cost calculation will be wrong.
Can Opportunity Cost be Avoided?
There are always alternative uses for your money. Some may be extremely high risk but provide well above average returns, or not, depending on what happens.
Sometimes you will choose to sacrifice the opportunity cost of more aggressive investing (eg highly leveraged shares) for a lower risk situation. You may prefer a very likely chance of a good return over a more uncertain chance of a high return (and some risk of capital loss).
How Opportunity Cost is Calculated
The expected returns from the two investments are compared. The opportunity cost is the difference between the higher and lower return.
My very first post in 2019 outlined my attempts to work out the opportunity cost of invest in property vs shares. Dare I look back and see how I did in retrospect?
My opportunity cost calculation at the time lifted from the original article.
I had $2,200 per month spare to invest.
|Returns||INVEST IN PROPERTY|
Long term returns ~7% but are extremely variable
Buy and sell costs
5-6% purchase cost & 2% selling cost
|INVEST IN THE STOCK MARKET|
Long term returns ~9% but extremely variable
Can be $10 / $10,000 (0.1%)
|Power of leverage||Can leverage up to 90% turning 7% returns to potentially 90% (minus interest)||Can leverage up to ~70% turning 9% returns to potentially 63% (minus interest)|
So I assumed a 7% return for a $600k property leveraged at 100%. My $2200 monthly surplus cover costs exceeding rental income.
I didn’t take into account rental income increasing over the years and the property becoming less negatively geared. I also considered the tax benefits of negative gearing separately. The maths gets a bit complex, and it’s probably best to be conservative with all assumptions.
I assumed 9% total returns for shares, a bit less than the S&P 500 accumulation index historic return of 10%.
Leveraged Property vs Leveraged Shares Opportunity Cost
Of course, the property won hands down. It’s not really a fair comparison.
The shares in this example are completely unleveraged because the thought of leveraging into the share market was too risky for me.
If we compare the effect of property leveraged at 100% (with equity from own home) and typical maximum share market leverage of 70%.
Here we can see the aggressively leveraged shares overtake the property after around 8 years. Because of the volatility of shares, leveraging is far more aggressive. A drop in values can lead to a margin call, where the bank is not happy with the level of risk when an investor drops below their acceptable loan to value ratio.
The bank can demand with a margin call that you invest the extra cash within days.
Leverage into property is not without risk, but the bank doesn’t demand you pay up immediately. Investors of dud properties can choose to bite the bullet and sell in order or hold until (hopefully) the value improves.
If you want to know how the property did in reality check out my 2-year update.
How Opportunity Cost Affects Decision Making
The above calculations are made on many assumptions. Opportunity cost can only be accurately calculated after the investment period has proven the actual returns offered.
As we need to choose investments before we invest, it’s important to attempt to make an opportunity cost calculation as accurate as possible. Try and avoid introducing too much bias into the equation.
At some point, you have to accept that you’ve made the best decision based on the information available at the time and take the leap.
Look back in a few years to assess the accuracy of your opportunity cost calculation if you dare!
Rent or Buy Example
Should you purchase a home in your current city or just rent?
There are many variables to consider, check out my article on rentvesting and my my opportunity cost from purchasing a home in a regional area.
To assess the opportunity cost of choosing to purchase your home, you need to know
- Rent you will be paying
- Anticipated returns from investments you could make if you continue renting
- Mortgage repayments
- Anticipated returns from investments you could make if you buy (if any)
- Anticipated capital growth returns from your purchased home
- Time frame
If you are staying put for 10 years, rents will increase. Interest rates are currently extremely low, but will eventually increase. The expected capital growth of your intended purchase and the number of years living in the property make or break the deal for renting or buying.
Dud Investment Example
Let’s catch up with Bob, our rural specialist doctor who purchased a house and land package in a regional town on 2014 for $240,000.
We first met Bob (who really lives in my head) in 2019. After 5 years of paying the mortgage, he was in the disappointing position to be $45,00 in negative equity. The property valuation came in at only $195,000 after a bad economic turn for the town. The rent was covering the mortgage repayments so there was no emergent need to sell. He certainly wasn’t going to sell at a loss!
But Bob is making a common error in his thinking. This is the sunk cost fallacy. The fact that he has lost money on this investment does not affect the opportunity cost of the decision to stay with this property, or cut his losses and invest elsewhere.
If we were logical investors, the decision of whether to sell and reinvest or hold and hope would be based on:
Anticipated property returns for the original property going forward
Anticipated returns if Bob sold up and invested elsewhere (another property of shares)
Transaction costs involved in selling the property and reinvesting
Property is particularly expensive to get in and out of, with purchasing costs of around 6% of the property value and selling fees around 2%. Over the long term, or if there is a large difference in potential returns between the investment choices, it becomes more logical to sell.
Dud Investment in Shares.
Earlier, you chose to buy Apple shares and accept the opportunity cost of the potential profits from buying CSL instead.
Now imagine the general public get fed up with Apple and it’s annoying charging port that has to be different. No-one is buying apple anymore, and it doesn’t seem likely the company is going to make a come back.
You decide to sell and buy CSL shares.
The sunk cost is the transaction fees (brokerage) you spend buying Apple shares, plus any losses. It is common for investors to hang on to shares in the hope they recover to the buy price. This makes no sense. Even if Apple manage to stage a comeback over the next 3 years, if CSL are expected to significantly outperform, it may be the more sensible investment going forwards.
When assessing the opportunity cost you would assess
Anticipated return of Apple shares going forward
Anticipated return of CSL shares going forward
PLUS transaction fees to sell apple, buy CSL and capital gains tax to be paid.
It’s tempting for investors who have purchased a “dud” to stick their heads in the sand. Or illogically wait for the price to return to their purchase price.
It’s hard to face up to the loss, but there is an opportunity cost to doing this.
A capital loss is when you sell an asset for less than what you brought for it plus costs of ownership. The silver lining is that if you make a capital loss, this can be used to offset capital gains.
So if you lost $10,000 on Apple shares, but made a $10,000 gain on another investment, you could offset the gain and pay no tax.
Why Opportunity Cost is Important
Investors are prone to all sorts of biases in investing. Trying to make decisions logically based on the best available information at the time is a good start. Spend the time to calculate as best you can the opportunity cost of your next significant financial decision. Don’t be fooled into the Sunk cost fallacy.
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Aussie Doc Freedom is not a financial adviser and does not offer any advice. Information on this website is purely a description of my experiences and learning. Please check with your independent financial adviser or accountant before making any changes.