The Opportunity Cost of Not Investing
Written by Whitney Elkins-Hutten
Director of Investor Education | PassiveInvesting.com
As a habitual optimizer, I’m always seeking to eliminate any friction in my environment that would rob me of my time and attention. I take the same approach when placing an investment and/or optimizing my investment portfolio to maximize my wealth. I call this process “reducing your opportunity cost.”
What Does “Opportunity Cost” Mean and Why is it Important?
The opportunity cost of an investment is the measure of what you are giving up when you choose one investment activity over another. It is important to learn how to calculate the opportunity cost properly as you could be leaving a hefty sum of money on the table… or if you decide not to invest because inflation and all this talk of recession have made you overly cautious.
How to Lower your Opportunity Cost?
Calculating the opportunity cost between two investment activities is simple. What gets more complex is how to extrapolate the opportunity cost impact to your overall portfolio and then mitigate your investment risk. Let’s dive in.
Step 1: Calculating Opportunity Cost
Let’s say you are in an investment that is yielding 2% annualized and you are considering another investment that yields 10% per year. The opportunity cost would be 10% (the investment you are not in) minus 2% (the investment you are in) which is 8%.
Opportunity Cost = 10% (the investment you are not in) – 2% (the investment you are in) = 8%
Step 2: Convert the Opportunity Cost to Dollars
Knowing the delta (or difference) is straightforward. But how do you find out your opportunity cost in dollars?
To find the opportunity cost in dollarsmultiply the opportunity cost percentage from Step 1 by the total money that you initially invested. So, if you have $100,000 invested in the 2% investment, your opportunity cost in year one is $8,000.
Opportunity cost (in $) = 8% x $100,000 = $8,000. So, the opportunity cost is $8,000… or is it???
Step 3: Compound Your Future Losses Due to Opportunity Cost
Most investors stop at Step 2 when calculating their opportunity cost. But let’s dive deeper…If you never made that $8,000 in year one because you stuck with your original 2% return investment, you lose out on ever investing (and compounding) that $8,000 in the future.
As a result, to measure the full impact of your decision on your portfolio, you must compound that $8,000 loss over your entire investing horizon.
In this example, if your investment horizon is 30 years, $8,000 compounded at 10% over 29 more years is $126,904 lost—this is your actual opportunity cost (not $8,000).
You can see this issue grows exponentially with every decision (or indecision).
The Most Important Step – Mitigating Risk
I’d be remiss to mention that fine-tuning your portfolio to eliminate the opportunity cost (especially uninvested cash) is more than chasing yield. As a savvy investor, you must know how to mitigate risk.
Therefore, it is imperative that you learn how to invest in conservative assets that preserve capital, create cash flow, hedge inflation, and generate tax benefits. Next, look for business-savvy ways to create equity and smart use of leverage.