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"Opportunity Cost" of a choice is the value of the best alternative forgone in order to pursue a certain action. In other words, it is the cost incurred by not enjoying the benefit that would be had by taking the second or third etc. best choice available. The concept of opportunity cost comes into play because resources are limited. Resources can be either time or money or both. Often, when people say that they wasted time doing something, what they mean is that their time could have been better spent doing something else and they incurred an opportunity cost. Here, the opportunity cost may be subjective and involve personal preferences. For example, if I like to spend time reading books then there is an opportunity cost of spending time watching movies whereas it will be the other way round for someone who loves watching movies. Similarly, a certain amount of money spent on acquiring an item has an opportunity cost. Again, the benefits can be subjective based on personal preferences. That is why it is said; the value of an item is perceived, hence variable, whereas the price is fixed.
In the investment context, opportunity cost means alternate investment options that may provide better returns for similar or lesser risk taken. Mostly, the opportunity cost is objective for investments and can be measured through mathematical models. Let me elaborate this with some cases that I have encountered while advising clients. The numbers used below are for illustration purposes only and may vary in actual cases.
Case 1 - Fixed Deposits Vs. Liquid Funds
Most Upper Middle Class people today fall under 30.9% tax slab, thanks to our Income Tax rules which have not kept pace with the inflation. Assuming a return of 9% on Fixed Deposits (a.k.a. FDs) and marginal tax rate of 30.9%, the post-tax return works out to be 6.22% per year. The same amount invested in Liquid funds, in the current scenario, may fetch post-tax returns of 6.5% - 7%. There is an opportunity cost of 0.25% to 0.75% when you invest in FDs. An amount of Rs. 10 Lakhs means an opportunity cost in the range of Rs. 2500 to Rs. 8000. Since banks have accounts and ready access to money, FDs are easily sold and for individuals, become a preferred option for parking money. Your opportunity cost becomes opportunity gain for banks.
Case 2 - Keeping money in Savings Bank account
This is a very common case where money from salary or other inflows is credited in the savings bank account and just stays there earning meager 3%-4% pre-tax returns. Though some banks have started offering higher savings bank interest but those are exceptions only. The opportunity cost vis-Ã -vis. Liquid funds, is a whopping 4%-5% post-tax. Rs. 10 lakhs lying idle in a Savings bank account would have foregone Rs. 40,000 to Rs. 50,000 of investment returns in a year.
Case 3 - Selling the winners faster and holding on to the losers
Lets say you have invested Rs. 100 each in two investments and one investment becomes Rs. 150 while the other becomes Rs. 90 in one year. If you need to sell one of the investments, which one will it be? Most people choose the one that has appreciated to Rs. 150. This is a very common behavioral bias of "selling the winners faster and holding on to the losers" that leads to opportunity cost. In this case, it is a double whammy because you have opportunity cost on both the winning and the losing investment.
Case 4 - Buying Unit Linked Insurance Plans Vs. Term Insurance Plans
Insurance companies never talk in terms of returns but rather the amount of money they will be giving you on certain dates. The opportunity cost of investing in ULIPs is two-fold because you not only get sub-standard returns but you also have inadequate risk cover. This is a very common situation that I see in most individual cases.
Many times, we worry too much about individual product returns. The best thing for an individual is to always consider returns on the overall portfolio. The portfolio should be designed based on the relevant risk profile. If major part of the investments is giving 6% returns then the return requirements are unreasonable from the minor part of the investments. In my experience, most people do not get more than 4%-6% returns on their overall portfolio due to lack of proper investment planning and as a result huge opportunity cost. Individual investors, if planning on their own, can take simple steps to avoid opportunity cost and enhance the value of their investments.
There is opportunity cost when choosing individual products in an asset class, e.g., large cap mutual funds. A large cap mutual fund investment yielding 12% is no good when the market and best mutual funds have given higher returns. This kind of analysis requires some involved mathematical modeling and data processing. It is better to take help from experts in such cases.
So, my advice to all investors is "Always think of your investments in terms of opportunity cost and you will see increased benefits immediately".
The writer is the Managing Director of Mitraz Financial Services Pvt. Ltd. and can be contacted at firstname.lastname@example.org