What is Opportunity Cost and how it can help you take better investment decisions

Published: January 18, 2020 10:32:35 AM

When taking any investment decision, make sure you also factor in the opportunity cost of your decision against multiple alternative decisions and take an informed call.

Opportunity Cost, investment, What is Opportunity Cost, investment decisions, opportunity cost formula, how to calculate opportunity cost, mutual fund, FD, NAV Opportunity cost is the cost of missing out on an opportunity to get higher (additional) returns on an alternative investment decision than the one chosen.

Investing is all about parking money in a financial product or economic vehicle in the hope of making more money than what was invested. Investors usually factor in many criteria—like returns or holding period or riskiness—to make that decision.

What if there were some hidden criteria that investors do not usually consider? Opportunity cost is one such criterion. It is the cost of missing out on an opportunity to get higher (additional) returns on an alternative investment decision than the one chosen.

Let’s see how it works in different situations.

The cost of not opting for an alternative investment

This is the typical scenario where investors fail to take note of an alternative investment option that could fetch higher returns than the option being currently considered. For instance, let us say a Mutual Fund investment can fetch returns of 12% over a 5-year period.

If you have already decided to invest in an FD for 5 years hoping to get an interest of 8%, then your opportunity cost of missing out on the alternative investment (the Mutual Fund) is 4% of the principal amount. So you’re better off not investing in the FD, but instead investing in the Mutual Fund.

The cost of doing nothing

Counter-intuitively, many small investors believe that there is no cost to doing nothing. This can manifest in a couple of ways. Investors sometimes sit with huge corpuses parked in their savings bank accounts, content with the 3.5-4% they are getting.

This is almost like “doing nothing” with your money since the savings interest rate hardly covers the increase in cost of living ie., retail inflation, whereas the same money parked even in a conservative instrument like an FD would have at least beaten or equaled inflation.

The cost of not disinvesting

Another way the cost of doing nothing manifests is the cost of not disinvesting. When a stock investor is locked into a stock whose price is falling and doesn’t pull out in time ie., does not “disinvest” in time, he risks losing more than he bargained for as the stock price plunges further.

Let us say an investor had bought Rs 1 lakh worth of a particular mutual fund at a Net Asset Value (NAV) of Rs 100 per unit, with the hope of making 10% returns in 2 years. However, the NAV falls to Rs 90 per share in 6 months and threatens to fall further. Now he has the option of disinvesting and reinvesting his Rs 90,000 in a stock that is projected to grow at 15% p.a. so that he still ends up with his targeted Rs 1.1 lakh at the end of 2 years.

If he does not disinvest and ends up with a fund value of, say, Rs 70,000 at the end of 2 years, then his opportunity cost of not disinvesting would be Rs 40,000. Remember that disinvesting is also an “investment decision”.

The cost of not borrowing

Many investors consider borrowing to be taboo. However, there is an opportunity cost of not borrowing too in certain cases. Consider the case of an aspiring entrepreneur who wants to start a venture with projected returns of 20% p.a. but does not have funds to kickstart it.

Now one option for the entrepreneur is to take a business loan at 15% p.a., launch her venture, and repay the loan from the business’ profits. In case she does not wish to take the borrowing route to entrepreneurship, then the cost of not borrowing in this case would be 5% of the loan amount not taken.

When taking any investment decision, make sure you also factor in the opportunity cost of your decision against multiple alternative decisions and take an informed call.

(By Hemanth Gorur, Co-founder, Hermoneytalks.com, and Managing Partner, Hubwords Media)

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