Opportunity cost is a well-known concept in the finance and economic world, but many know very little of or understand its implications when it comes to making investment choices among several assets.
Opportunity cost is the value of what you lose when you choose from two or more alternatives. It’s a core concept for both investing and life in general. When you invest, opportunity cost can be defined as the amount of money you might not earn by purchasing one asset instead of another.
In layman’s terms, opportunity cost in relation to making investment choices is basically asking the question of what else could an investor invest in with his capital and what is the potential gain forgone after choosing an asset to invest his capital.
According to Warren Buffett, “The real cost of any purchase isn’t the actual dollar cost. Rather, it’s the opportunity cost—the value of the investment you didn’t make, because you used your funds to buy something else.”
To this end, Nairametrics was able to interview some investment professionals to ask the question of what should guide an individual’s opportunity cost before they make an investment decision.
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Dr. Oladipupo Tijani – Head Business Advisory, Norrenberger Financial Group
Speaking with Tijani, he opined that both risk and opportunity cost should be strongly considered. He stated, “When making investment decisions, it is important to consider both risk and opportunity cost. Generally, there is an inverse relationship (when one goes up the other comes down, and vice versa) between risk associated with an investment and the associated returns. In determining opportunity cost for any two investment options, it is essential to understand the risk associated with both.”
He further stated, “In general finance theory, the greater the risk involved in an investment, the higher the returns it provides. Depending on the situation, it might be difficult to compare opportunity costs of shares/stocks, with risk-free investments like the Federal Government Treasury Bills. The reason is while there is a huge opportunity cost for choosing T-bills over stocks, the liquidity and most importantly security it provides may guide your preference over stocks.
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“Although it has been argued that holding cash is safer and will usually keep up with inflation in nominal terms, if inflation is accompanied by rising short-term interest rates, holding exclusively cash may lead to huge opportunity losses.
“Year-to-date returns on Nigerian equities market for instance illustrate missed financial opportunities, against when cash is held. The NGX year-to-date recorded 22.17% returns while some large, capitalized stocks have also returned up to 99.52% as of 20 July 2022. Treasury Bills returned 5.7% year on average.”
Tijani went on to illustrate stating, “To put it in perspective, N100,000 invested on the NGX at the beginning of 2022 would have grown to N122,170 by 20 July 2022. The same N100,000 invested in T-bills would have grown to about N103,250 (on annualized basis, if you consider stop rate other than yield). Thus, the opportunity cost for conservative investors who chose to invest the N100,000 in FGN T-Bills at the beginning of the year would be N18,920 (N122,170 – N103,250). This is without reference of current headline inflation trend, or the steady loss in purchasing power cash falls victim to over time.
“Without doubt, the decision around investing is inherently informed by opportunity cost. However, as an investor, evaluating the opportunity cost of investing may be thought-provoking, and the number of opportunities to consider may seem intimidating. You do not want to make the wrong investment decision and incur losses, after all.”
On what to guide an investor’s opportunity cost when making an investment decision, he stated, “Available funds. People generally want to obtain high returns on investment without much consciousness to risk appetite. With financial considerations to weigh, the key question to ask before making an opportunity cost decision is what other investment options are available to channel the available funds? Your decision to invest your only available N1 million cash in T-bills means you will never get that specific N1 million back (all other things being equal). That N1 million cash that could have been invested in personal development (e.g., training), bonds, stocks, held as cash, or on a new and improved website for your small-scale business, is the opportunity cost of choosing to invest in the T-bills.
“Time. As an investor, never forget that time is an essential commodity. In the opportunity cost realm, time can be even more priceless than cash. Consequently, when making any investment decision, always factor in the time needed (or saved) by choosing a specific investment opportunity. In other words, once a decision is taken at a particular point in time to invest in certain security, you will most likely need some time to be able to terminate, reinvest, and/or explore alternative investment options, depending on the features of such investments.
“Effort. The higher your overconfidence bias leads you to just any available investment choice, rather than thoroughly evaluating factors such as appropriate mix, cost averaging, portfolio balancing, and avoiding circumstances that lead to fraud, the higher your opportunity costs.”
He concluded by stating, “When it comes to investing, overall, the capability is limited in everyone. There is but a trade-off. Opportunity costs, then, are simply a matter of deciding which trade-offs you can live with.”
Temisan Agbajoh – Head, Digital Asset Desk at Kudy financials
Temisan believes that considering the value of opportunity costs can guide an investor to better profitable decision-making. He stated, “The calculation for opportunity cost is FO-CO which is simply the difference in the expected yield on the foregone option and the chosen option. It doesn’t stop there, you also have to take into consideration your risk appetite and the available options. In simpler terms, look at the investment options available to you and calculate the expected returns on each of them, then find the difference between them to know the foregone alternative. Pair this with your risk appetite and the risk ratings behind the investments.
“On a scale of 1-5, cash in the bank is 1 because it’s protected by insurance and backed by the government while a 5 will be stocks and digital assets due to their high volatility. Then the last thing to hold it all together is the time frame for your investments, you cannot use short-term money to make long-term investments. Money for rent should not be locked in a 5-year Eurobond.”
Temisan concluded by giving references to three considerations before making proper investment decisions. They are; Difference in expected yield, risk rating of the products and personal risk appetite and Time, the duration of the investments.
Opeoluwa Dapo-Thomas, CEO Perth Partners
Opeoluwa mentioned a few things to consider before making an investment choice. He stated, “Now it’s common knowledge that they are a variety of asset classes and options in the financial markets. Now as a potential investor, you would have to forgo certain investments because of the paucity of funds or rather limited allocation size. So before making a choice, they are so many factors to consider – starting with your investment objective, risk appetite and investment horizon.
Now, what are you investing for? That answer will determine the asset you want to purchase. Capital appreciation or dividends? Also, your risk appetite is important – it determines which asset to forgo and lastly, how long are you investing for? If you need to be liquid in the short term, assets that can be liquidated can be prioritized. So, these are the things investors should consider.”