When opportunity costs

By David McEwen

Monday 25th February 2002

Many investors are nervous about taking risks with their investments, and rightly so. As this column has said many times, once you have lost some of your hard-earned capital, what's left has to work much harder to produce an acceptable return.

On the other hand, being too safe can severely limit your wealth. Putting your life savings in a bank deposit account is pretty safe but the return, after deducting tax and inflation, is virtually zero.

The secret to successful investment is in managing risk, not trying to eliminate it.

An easy way to achieve this is to put a large portion of capital in low risk, low return assets, some in medium risk/return and a little bit in high risk/return assets. The high-risk assets are most likely to lose money, but that's not too bad because only a fraction of the total portfolio is invested in them. However, they are also likely to be the best performers and can earn as much in a good year as the rest of the portfolio put together.

One of the misconceptions about safe investments, especially ones like government stock, is that there is no disadvantage in holding them because they always retain their value. However, many people in this camp fail to take account of something that is costing them plenty. This is known as "opportunity cost".

Let's look at an example. A nervous investor with $10,000 to invest chooses, safe, reliable government stock, yielding about 4.7%. The best thing about it, they decide, is that there's no potential for capital loss and they can look forward to a return of $470 each year.

But what about their opportunity cost? Now let's consider the effect of putting equal portions in government stock, a bank term deposit, a selection of local government and corporate bonds and in the share market's 10 largest companies? A similar result could be achieved by investing in unit trusts that specialise in these areas.

At current rates, our investor could expect to make around 4.7% on the stock, 6% on the deposit, 8% on the bonds and 10% on the shares. If so, each year their gross return would amount to $717.50.

This is $247.50 more than by simply holding government stock, an increase of 52.7%.

Therefore, our nervous investor pays an opportunity cost of 2.5c in the dollar each year just to keep their money super safe. While their nominal risk does go up through diversification, realistically the chance of losing all of their investment in any one asset class is extremely low.

Some might say the concept of opportunity cost is of limited use. After all, if one has investment capital, there will always be an opportunity cost relative to the biggest return around, which could come by betting it all on the next horse race or spin of the roulette wheel.

That's true, but one cannot escape the fact that there is an unbreakable connection between risk and reward. Prosperity with peace of mind comes from finding the right balance between the two - and this differs for everyone.

Many New Zealand investors do not have that balance and are missing out financially as a result. At least by considering the concept of opportunity cost, investors can measure the impact of being cautious - and decide whether they have the right balance.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz

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