Many investors evaluate investment opportunities as a tradeoff between risk and return. The basic tenet is that to become an optimal investor, one must define an acceptable level of risk and attempt to maximize return without exceeding this predetermined level of risk. This is absolutely correct — but it’s incomplete.
The reason this correct thinking often yields flawed results is that most of us don’t have a complete understanding of risk, and, therefore, we aren’t able to accurately define it at the onset. The prevailing definition of risk most investors consider is simply principal risk. Principal risk can be defined as the likelihood of an investment losing money. If I invest a dollar, what are the chances that at some point in the future it is worth less than a dollar? This is an important definition of risk, but there is a concept in risk and wealth management that precedes this basic risk, and that’s the idea of opportunity cost.
Before an investor can evaluate the desirability of an investment, they first must make the decision to invest those dollars in the first place. Author Dan Ariely defines this in his book, Dollars and Sense, saying “the way we should think about the opportunity cost of money is that when we spend money on one thing, it’s money that we cannot spend on something else, neither right now, nor any time later.”
There are a couple of common ways we most often see investors ignoring this important “cost” in their decision-making.
The first is probably the most obvious, which is the decision to leave cash that would otherwise be earmarked for investment on the sideline due to some fear of loss. Many investors were very uneasy about what to expect with the economy and stock market following the COVID-19 pandemic, and the first instinct for some was to seek safety for their money and keep it in cash rather than exposing it to the risk of the stock market. But what was the cost for the “safety” that cash provided? It’s true that cash didn’t suffer any principal loss, while the stock market has proved to be pretty volatile over the last few years, but consider the purchasing power of the investor who went to cash compared to one who was invested. Since the start of 2021, the S&P 500 index has grown 6% in real (inflation-adjusted) terms, with $1.00 now providing $1.06 of purchasing power. Meanwhile if one just held cash, their purchasing power declined by 18%, with $1.00 now being worth $0.82 in real terms.1 The opportunity cost of lost growth in combination with declining purchasing power resulted in significantly more risk than they may have initially perceived for those who made the decision to remain in cash for the last three years.
This chart shows the relationship between S&P real returns (adjusted for inflation) and purchasing power from 1/1/2021 to 8/31/2023. S&P real returns end at $1.06, while purchasing power ends at $0.82.
The decision to remain uninvested vs. investing might be the most straightforward example of ignoring opportunity cost, but here’s a second example commonly seen in real estate. Many times we’ve heard some version of “real estate is the best way to grow wealth.” We hear stories of houses purchased for $20,000 that are now worth $500,000. While this narrative isn’t completely untrue — and there are certainly many people who have grown wealthy investing in real estate — it’s not the whole story.
Looking at ending value minus starting value is a simple way to define growth, but it ignores the costs that were incurred along the way: taxes, insurance, repairs, updates, etc. Each of those costs took dollars away that could have been spent or invested elsewhere. For those managing rentals, this produces additional income but also comes with additional costs: property management, additional taxes and insurance, vacancies, bad tenants, etc. It also comes with the cost of time and headache associated with the management of these properties. Time and peace of mind may not be tangible costs, but they’re certainly factors that should be considered in the decision-making process.
It’s worth digging into the initial narrative that real estate is the best way to earn wealth. Since 1990, the average home price in the U.S. is up more than 300%, which is more than double what inflation has been during that time period. A home purchased for $100,000 in 1990 would now be worth $405,000.2 Many homeowners (rightfully) feel like they have done very well and are probably very happy to have owned a home during this time. However, during the same period, the S&P 500 index is up 2400%.3 This same $100,000 used to buy a home would now be worth $2.5 million if invested in the S&P 500.
This chart shows the relationship between the Case-Shiller Home Price Index: National (I:CSHPIN) % change and the S&P 500 Total Return (^SPXTR) Level % change between 1990 and 2023. The Case-Shiller Home Price Index: National (I:CSHPIN) % change remains mostly flat with a mild trend upward, ending at 305.4%, while the S&P 500 Total Return (^SPXTR) Level % change trends much higher, ending at 2,370%.
The lesson to be learned from these examples is that it’s not always accurate to judge a decision based solely on the outcome. In our examples, a dollar in cash didn’t lose any principal and was therefore “safe,” and owning a home could have created a lot of wealth. But the salient comparison in each is to look not at what the investment did but rather at what it could have done. Considering these opportunity costs is an important factor in good decision-making in both investing and in life.