Opportunity Cost: Understanding the True Cost of Decisions

Opportunity cost is a fundamental aspect of decision-making that often goes unnoticed until one delves into the intricacies of finance.

It’s the realisation that every choice we make comes at the expense of something else. Whether it’s dedicating time to work, allocating funds to investments, or even the act of delaying a decision, there are always costs involved.

Consider this: if I commit myself entirely to work, it’s likely to impact my fitness and relationships. Similarly, if I invest $250k in a Specialist Disability Accommodation (SDA), I’m sacrificing liquidity and potentially missing out on other investment opportunities. Even delayed decisions incur costs. For instance, if I take six months to decide on investing in an SDA property, I’m not only losing potential income but also facing the risk of price increases in the meantime.

Let’s break it down further. If I leave my money in a bank earning a 4% interest rate while the expected return on an SDA investment is 12%, I’m essentially losing out on 8%.

However, moving funds into the SDA entails risks, as the bank offers security that the investment may not. Liquidity and optionality, often overlooked, carry significant value. For instance, an index-tracking ETF is highly liquid, whereas shares in an exploration mining company might only trade once a month. When calculating expected returns, one must account for the lack of liquidity and demand compensation accordingly.

The concept of optionality becomes apparent when we delve into real options, though it’s beyond the scope of this discussion. In essence, having the flexibility to exit a decision or increase one’s position later provides valuable optionality. This is particularly relevant in decisions like renting versus buying, where renting typically offers more flexibility.

In summary, the cost of inaction is often overlooked by many retail investors. While diligence is crucial, prolonged decision-making can be detrimental. This is where seeking professional consultancy holds immense value. For instance, if consulting a professional can expedite my investment decision by six months, and the expected return on a $1 million investment is 12%, the value gained (minus the 4% earned in the bank) amounts to $40 thousand.

Understanding opportunity cost is essential in making informed decisions. While it may seem daunting at first, recognising the trade-offs involved ultimately leads to better outcomes in both personal and financial spheres.

Thanks for reading, Dave G Stewart.

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