The Cost of Investing: Opportunity Costs

Investing is not all that difficult, but you do have to pay attention to what economists refer to as the opportunity cost of investing. In this context, opportunity cost is the cost of not earning income that you might otherwise have earned.

Consider the case of an investor who has two investment alternatives, one with a return of 5% and the other with a return of 6%. Other things being equal, it should be obvious that buying the investment with the higher yield is the right decision. If you were to choose the asset with the lower rate of return, you’d be giving up that extra 1% of income, so your opportunity cost would be the difference between the two rates. Therefore, if you were to choose the lower yielding asset, your opportunity cost would be the dollars you gave up. A problem with this calculation, however, is that it is an assumption of perfect information.

Of course, we can’t expect everyone to be aware of all the possible choices to consider when deciding where to invest. In this case, for example, the opportunity cost to the person who chose the 5%-yielding investment would be even greater if a third investment opportunity with an even higher yield had been available. Many calculated measures of opportunity cost may understate reality because of this consideration. Furthermore, assuming that “all else is equal” is problematic. Direct comparisons are difficult because different asset classes have different types of risk. A comparison between stocks and bonds is a classic case. Opportunity costs can be significant, but they are also difficult to measure with certainty.

Best practice calls for comparing the expected returns of stocks with those of bonds, but assessing and quantifying the expected returns of these asset classes requires a certain amount of guesswork. We can be reasonably confident that stocks will outperform bonds over, say, a 10-year period. But it’s hard to be particularly confident about any explicit numerical value for the expected rate of return that we might come up with. The best we can do is pick a number that seems consistent with experience, but over what time horizon? Depending on how far back your sample goes, you’ll get different answers.