Diana Clement: No decision is made without sacrifice

Diana Clement

One of the biggest mistakes an investor can make is not to understand the importance of opportunity cost. According to the Economist the true cost of something, or opportunity cost, is what you give up to get it. That means the economic benefits that you did without because you bought or did something else.

On the most basic level opportunity cost is choosing, for example, to leave money in an online call account, for which you'd get up to 4.5 per cent a year in a bank term deposit currently, compared to investing in shares or funds where returns may be in double digits if the markets rebound.

Even going for a walk may appear to cost nothing, says the Economist in its definition of opportunity cost. "Until you consider the opportunity forgone to use that time earning money."

Opportunity cost is a very simple concept with powerful implications. Those everyday trade-offs we make when investing - and just living - can have long-term implications for our wealth.

The problem, however, when analysing comparative advantages between investments, says Murray Weatherston, director of Financial Focus New Zealand, a financial planning firm, is that it enters the realm of uncertainty.

"There is an old Chinese proverb that says forecasting is always difficult, especially in respect of the future," says Weatherston.

By putting money in term deposits or paying down debt, there is certainty, whereas buying shares does not guarantee a gain and, in fact, could result in a loss.

In recent years, says Mike Newton, of Newton Ross Private Wealth Management, investors haven't had to think much about opportunity cost because they've been able to get high returns on their deposits. "Now in a normal yield curve short-term rates are lower than longer-term rates. There is a really big opportunity cost of staying in cash. It means investors are being forced to take on risk."

In the current market, says Fenton Peterken, financial adviser and accountant at Capricorn Group in Whangarei, many investors are losing out on potential opportunities in the stock markets by holding back.

"I say to clients when there is a shoe sale you go out to buy shoes, but when there is a share sale, why do you panic?" When retail jewellers were having sales recently, Peterken commented to clients that the best jewellery sale around wasn't on the high street but was Michael Hill Jewellers' share price, which had dropped by 50 per cent.

Typical of the failure to weigh up opportunity cost, says Peterken, is a client who decided to sell his shares at the bottom of the market to pay off debt. By doing so he was guaranteed 7 per cent, because that is the interest rate he was paying on the mortgage. Yet since March some stocks have rebounded by 30 per cent.

Financial planner Robert Oddy, of International Financial Planners, adds that leaving your money in the bank in the current low-interest environment is "probably the silliest thing of all".

Property investors also need to consider opportunity cost. Money sunk into a property can't earn interest or dividends. If that property is negatively geared, there may be tax advantages. But do those tax advantages and the potential capital gain outweigh the interest you could earn on deposits and bonds?

There's even an opportunity cost with your own home. If you decide, for example, to live in a $1.5 million four-bedroom house rather than a $600,000 one of the same size, you've chosen to tie up a degree of your capital in a non-productive asset.

As headlines screamed last weekend, it may be cheaper to rent than to buy a home at present. Investment properties may be different because they earn income and have the potential for capital gain.

Peterken, who is a property investor and treasurer of the Northland Property Investors' Association, as well as being a financial planner, doesn't believe that the opportunities in the property markets are as cut and dried currently as sharemarkets.

Talk of a "rebound" in the residential property market is keeping Peterken away. He believes that later in the winter any mini-rebound will be over and opportunities better.

Another opportunity cost is the choice by businesses whether to rent or buy premises - that is assuming you can't work from home and make your own home tax-efficient.

In this market, says Kevin Mark, of New Zealand Commercial Property Brokers, a hypothetical $1 million building can be let for $80,000 a year on a typical lease but finance costs to own your own building will be $50,000 to $60,000 a year at today's interest rates if you have borrowed 100 per cent. That assumes you have other assets to borrow against for bank security. There is, of course, a cost associated with the equity, whether that was a cash deposit or borrowing against your own home or other property.

Opportunity cost isn't just limited to investing. Many applications exist for it in personal finances. "It's important that people realise what their opportunity cost is when they invest. That is what financial planning is all about," says Newton.

The most obvious place to see lost opportunity cost in day-to-day life is in our spendthrift culture. Every dollar spent at the takeaway bar or, even worse, spent on interest payments to buy consumer goods, could be invested in the first place and grow.

Even $10 a week invested at a 7 per cent rate of return with the interest compounded would add up to $35,318 over 25 years. Spend that $10 and you'll have nothing. Use it as a deposit for consumer goods bought on credit and the opportunity cost is amplified.

Another opportunity cost being considered in the current economic environment by an increasing number of people is going back to university or other training. There is an enormous financial cost in this - especially if you study full-time. In that case you will both pay tuition fees and lose your income. For many people that additional study will pay off financially in the long run. But not for all. There is also an opportunity cost in choosing one course over another.

Other applications for opportunity cost include:

* Time management

* Career choice

* Production possibilities.

Taking advantage of opportunity cost requires some flexibility in your investing strategy. No one can predict when opportunities arise. This led one letter writer to the Herald to say that he saw the opportunity cost of investing in KiwiSaver as too great. As a business owner, had his business got into problems and his investments been tied up until retirement, he could have lost much more.

Yes, KiwiSaver will help some retire with more than government superannuation to live off. "What's not so obvious is that many of them might have broken free to financial freedom if they had the use of all of their money at a critical time," he wrote.

The question for investors is would having the ability to invest that money themselves over the years outweigh the $1000 kick-start and annual government sweeteners for KiwiSaver?

If, conversely, you're someone who is prone to all of the behavioural faults of investors, such as buying high and selling low, then the comparative advantage of investing in KiwiSaver for you may be better. That investment may earn the opportunity cost of the capital invested in it.