One of the most important concepts in economics is opportunity cost. In this post, we will dissect the opportunity cost concept and more importantly, contextualise its use in our own financial decision making. By the end of this, you will think like a financial planner and will make the best use of your resources, financial and otherwise.
Opportunity Cost…The Cost of Doing Nothing?
Some might think that opportunity cost is the cost of doing nothing with your money. But actually, opportunity cost is the difference in returns between two options. To know your opportunity cost, you need to answer the following question: How much money would your money have made if it is was invested? This question presents an alternative to spending or saving your cash that is always available to you. This alternative is investing, but what you invest in makes a world of a difference. In a simple equation form, opportunity cost is as follows:
Opportunity Cost = Returns on Best Available Investment – Current Returns
So How Much Money Exactly Am I Leaving on The Table?
To answer this question we need to know the best returns we can get with certainty. We can’t really consider saving accounts as our “best available investment” because there are better returns out there. The expected returns on other investments are much higher but require you to be invested for a longer time. When you put your money away in a saving account for a year, you expect the annual interest rate with 100% certainty. When you invest in investment grade corporate bonds, you can expect higher annual returns with less certainty. Volatile assets like gold and stocks leave you with an even lower chance of achieving their average returns in a 1 year period. This means that to use the average return of gold or stocks in working out the opportunity cost, you have to stay invested for more than a year.
How Long? and For How Much?
It depends on the asset class, but with volatile assets, it is usually more than 10 years. We summarise below the average returns recorded, and the associated time periods.
- Investment Grade Corporate Bonds returned 5% per annum on average from 1920 to 2020.
- Gold returned 5% per annum on average from 2005 to 2020
- FTSE 100 (largest 100 companies in the UK) returned 8.4% per annum on average for every 10 year period recorded since its inception!
- US stocks returned 10% per annum on average for every 20 year period recorded between 1920 to 2020!
What is interesting here is that UK and US stocks have had a 100% chance of achieving higher returns than bonds and gold over 10 and 20 year periods, respectively. This gives us confidence to use their average returns as inputs to our opportunity cost calculation with one caveat. We need to lock up the money for 10 to 20 years for our calculations to be realistic. Let us now discuss how this information feeds into our financial decision making, with some examples.
How Does This Help My Financial Decision Making?
1. Comparing Investments
The simplest application of opportunity cost is when comparing two investments. The investment with the highest risk adjusted return is better. However, the holding period needs to be the same for both investments for the comparison to be fair. Remember, UK and US stock markets have consistently delivered their historical average returns over 10 and 20 years.
Example 1: Arbitrary Investment vs UK Stock Market
Investment A offers 4% annually over 5 years. This means that it should also offer 4% annually over a 10 year period. For simplicity, it is assumed that Investment A’s returns are guaranteed. In actuality, investment returns vary and therefore an average is usually taken. Using the UK stock market as the best available investment, the opportunity cost of investing in Investment A is:
8.4% UK Stock Market Return – 4% Investment A Return = 4.4% Opportunity Cost
You miss out on 4.4% per year by investing in Investment A. You are better off investing in the UK stock market.
Example 2: Buying a House vs Investing the Deposit (And continuing to rent!)
This is not very straight forward, because there are a bunch of other inputs other than the return of the market and return on property. But there is an opportunity cost here, albeit much more complicated to work out. Unfortunately, there is no easy answer as it is varies for each person and scenario due to how many moving parts and variables there are to be considered. Our best solution to you here is subscribing to our newsletter for exclusive access to handy spreadsheets that compare buying a house with investing and renting. The results of which, we endeavour, will yield the best answers in consideration of your individual your situation/s.
2. Comparing Investing with Paying Down Debt
The second most popular use case of the opportunity cost is comparing paying down debt and investing. This is simply done by comparing the investment return and the interest rate on the debt. The opportunity cost in this case is the difference between the two. Your cost could be in paying more interest than you should, because the interest rate is higher than your returns. It also could be on missed return because the interest rates are too low. One popular example of this is overpaying your mortgage. Surely you will save some money on interest payments, but you probably lost a lot more by missing on market returns.
Example 1: Credit card debt vs investing
Credit card debt of £1000 carrying 24% interest per annum. Is it better for me to invest and pay the minimum interest payments or pay down the debt? This may be an obvious one, but just to illustrate again the opportunity cost:
8.4% per annum return – 24% annual interest = -15.6% opportunity cost
You notice here that the opportunity cost is negative. This means that investing will cost you 15.6% annual loss in interest payments. You need to pay down your credit card debt, it is a no brainer.
Example 2: Mortgage debt vs investing
Mortgage balance of £200,000 carrying 2% interest per annum. It is clear that there is an opportunity cost here.
8.4% per annum UK market return – 2% interest per annum = 6.4% opportunity cost
This tells you that you will miss out on 6.4% a year on any mortgage overpayment. 6.4% return compounded over 10 years worth of monthly overpayments would be a rather hefty sum so you should invest any extra money you have rather than overpay your mortgage. In fact, since this is a mortgage and is likely to have a 20+ year term, you can use the US market returns instead as the best available return. This increases your opportunity cost to 8%!
3. Comparing Debts
Interestingly, opportunity cost may also lie in your debts. If you can use one type of debt to pay down another, you can and should work out the opportunity cost of doing so.
Example 1: Car Finance vs Mortgage
You have a car loan with 8% interest and 2% interest mortgage. In this case, the opportunity cost formula is as follows:
2% Best Available Interest Rate (mortgage) – 8% Current Interest Rate (car finance rate) = -6% opportunity cost
This shows that you are losing 6% a year in interest on the car. You are literally better off taking money out of the property to pay down the car. You will save that 6% interest on the outstanding amount of the car loan. This saving is the opportunity cost in this scenario, it is how much you lose when you do not take action.
4. Comparing DIY and Hiring a professional!
Believe it or not, there is an opportunity cost associated with doing something yourself versus hiring a professional. It all comes down to your hourly rate. If you make £9-10 an hour, then you are probably better off mowing your loan and cleaning your home. If you are making £30 an hour, then there may be losses associated with doing something yourself instead of just hiring someone. The key here is to know your hourly rate to determine if something is worth doing or not.
Do I Always Have to Use Stock Market Returns?
No you don’t. If you have other investment opportunities available that will deliver returns with high levels of confidence, you can use those. The key idea is that an alternative is always available.
In Summary
We introduced one of the most important economic concepts in the context of our financial decision making. Now, you can start thinking like a financial planner. But to make the best financial decisions, you need to have visibility of your assets and your debts. Subscribe to our weekly newsletter to get early access to our work and nifty tools to track your budget, investments and net worth!
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