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Dejargoned: Opportunity cost

It is the advantage you forgo in choosing one alternative over the other

This is an important concept to understand when you look at investment alternatives. Opportunity cost is the advantage you forgo in choosing one alternative over the other. Let’s say you have the option to buy vegetables at your local vendor for which you have to drive to the market, or to order online. Your opportunity cost in the first option is the time it takes to go to the market. In the second, it is the inability to choose the quality of vegetables. Depending on whether time, money or quality is more important, one may choose either of the options. In both, there is a benefit and an opportunity cost. Let’s see how this can potentially impact your choice of investments.

EQUITY

Equity as an asset means investing in stocks and shares. You can do this either by buying directly through an exchange or through equity mutual funds. Equity shares are traded on a daily basis through an exchange, which means prices change with each trade or each trading order. This price change is referred to as volatility. But over a period of time, the price of share moves towards the intrinsic value or the value that is determined on the basis of a company’s earnings growth and other financial metrics. The outcome, however, is uncertain. Also, because it is about investing in companies the potential return from equity investments somewhat follow the expected earnings growth trajectory of the underlying companies.

Data shows historical long-term returns for this asset class to be above long-term inflation. If you want to invest in equity to earn above inflation returns in the long term, your opportunity cost is enduring daily price changes or volatility in the short-term and also the inability to know the return in advance.

FIXED INCOME

Investing in fixed income means buying a security where the payout is either known in advance, like in case of deposits and bonds, or is fairly certain, like in the case of money market and short-term income funds. Thus, unlike equity, here you have the benefit of knowing in advance how much you can potentially earn on an investment.

In case of mutual funds, there is some daily volatility in price, but that doesn’t take away from the expected return. But fixed income products such as bank deposits and even Public Provident Fund aren’t able to give above inflation returns in the long term. Similarly, with gold as an investment product, the advantage is that it acts as a hedge against inflation but, unlike equity (dividends) and fixed income (interest), gold is not an income-generating asset.

In real estate, too, the opportunity cost is the lack of liquidity in exiting. This kind of choice is also an indication of your risk appetite.

Not just asset classes, products within each asset class can have opportunity costs. The costs for each product, exit penalties, tax treatment and other aspects such as lock-in and returns determine the opportunity cost.

Just like in case of buying vegetables, one investor’s opportunity cost would be another investors’ advantage. Before choosing one product over another, weigh the opportunity costs most relevant to you and then decide.

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