The Cost of Lost Opportunity

During vacations, you may decide to visit a hill station, but it comes at the cost of losing the charm of a serene beach. Alternatively, you might decide to go and explore the historical monuments to marvel at their architecture, but it also comes at the cost of losing the fun and awesomeness of visiting a modern theme park.

Here is another one. You might not take any decision, or decide not to go anywhere, but at the cost of all the fun, excitement, serenity, chillness, awesomeness and everything above.

There is a cost attached with every decision, or even a 'no-decision'. And that is the Cost of 'Lost Opportunity'. Let us study how it applies to your personal finance.

In microeconomic theory, the 'Opportunity Cost', or 'Alternative Cost' of making a particular choice, is the value of the most valuable choice out of those that were not made. When an option is chosen from alternatives, the opportunity cost is the "cost" incurred by not enjoying the benefit associated with the best alternative choice.

Let us call it as the Cost of Lost Opportunity.

My experience dealing with thousands of freedom seekers clearly demonstrates the devastating effects of not understanding this cost. There are many examples from our personal finance space when we just let the situation be, without taking any decision, and feel that we are in the 'safe zone'. Here are a few examples which I have repeatedly seen:

(1) Holding on to Loss Making Stocks
Even though their Intrinsic Value of a Stock clearly tells us to sell it, we tend to hold on to loss making stocks in the hope of recovering the invested cost. We do not "act". We do not understand that loss making is as much a part of Stock investing as Profit Making, and that it is fine to lose a battle in order to the win the war. We forget the basics, and go with the noise. 

When we are not selling the stock, and hoping the stock to recover, we are taking a decision sub consciously, and the (in)decision is not to invest the current value of stocks in other profitable options available today. And each such indecision has a cost attached to it - The Cost of Lost Opportunity.

(2) Holding on to Real Estate
This is so typical among us Indians. We buy real estate as an investment, and just wish to hold on to it eternally. Even if we are ready to liquidate it, we are usually waiting for the real estate market to hit the "right price" before we sell it. Day in and day out, I deal with investors who feel that the real estate market is currently down, and that they would sell their real estate as soon as it comes up to their minimum benchmark level. 

Our current returns from real estate may be pathetic (even 0% or negative in some cases), but we keep holding on to it - in a hope of recovery. What we are not realising is that by holding on to it, we are deciding not to invest in another investment option which may be fetching 8-10% with almost 100% predictability. We are paying the Cost of Lost Opportunity by clinging on to our real estate.

(3) Waiting for a Tenant giving the 'right' Rent
I have experienced it myself and seen so many fall in this trap. Flat Owners would wait for 2-3 months to get a tenant who can pay 10-15% better rent. They tend to ignore the fact that with 2-3 months wait without rent, they have already lost 20% of the annual rent - a clear case of Cost of Lost opportunity. So, even if they get a tenant at the desired rent, they are already on the losing side.

More Examples?

The meaning of the concept of opportunity cost can be explained further with the help of following examples:
(1) The opportunity cost of the funds tied up in the one's own business is the interest that could be earned on those funds in other ventures.
(2) The opportunity cost of the time one puts into his own business is the salary he could earn in other occupations.
(3) The opportunity cost of using a machine to produce one product is the earnings that would be possible from other products.
(4) The opportunity cost of using a machine that is useless for any other purpose is nil, since its use requires no sacrifice of other opportunities.

Thus opportunity cost requires sacrifices. If there is no sacrifice involved in a decision, there will be no opportunity cost. In this regard the opportunity costs not involving cash flows are not recorded in the books of accounts, but they are important considerations in business decisions.

A real life example in Personal Finance
There are umpteen examples day in and day out to demonstrate Cost of Lost Opportunity. It never "feels" like a cost being paid - though it actually is.
The below example is for a real estate investment, but applies equally to other investments like Stocks, Rental Income and everything else.

One of the freedom seekers in our ELITE Program had a Real Estate investments worth around 35 Lacs.
He had been recommended to liquidate these investments (and re-invest in other options), since real estate was a low ROI investment, and the seekers portfolio demanded better returns as well as better liquidity.
Seeker was open to new ideas and was therefore prepared to sell off the real estate investment.
After about 12 months of tracking his portfolio, the status on Real Estate investments was the same.
Our ROI Review suggested that the seekers portfolio was lagging behind the expected ROI goals as per the financial freedom plan.
During one of the follow up interactions with the seeker, I found out the reason for this poor ROI and delay in selling off a poor performing Asset as Real Estate. The seeker categorically mentioned his positive intent to sell off the real estate, but also emphasised on the fact that the market was currently down, and he is not getting the buyer for 35 Lacs. He was just waiting for the buyer to be ready to pay 35 Lacs.

A simple and common case like above can easily be explained below to emphasise the cost he is paying for lost opportunities.

Case 1 (Wait for the right price) :
The invested Real Estate is worth 35 Lacs of money returning 1% ROI.
Let us assume that the seeker decides not to sell this investment for anything less than 35 lacs and is waiting for the right buyer to buy it at the right price.
Let us say that he has to wait for 1 year to get the right bargain, and sell them at this price.
Though there were no guarantees that he will get his demanded price after 1 year, but let us be optimistic from the seekers perspective.
He gets the buyer and also gets his 35 Lacs + 1% appreciation after 1 year.
His returns after 1 year = 35.00 Lacs + 0.35 Lacs (1% Capital Appreciation) = 35.35 Lacs.

Case 2 (Sell Immediately) :
The seeker understood the cost of lost opportunity, which exists every moment in every investment.
He gets ready to give a discount on the price in order to sell it immediately. Remember that he is offering discount to cover a part of the cost associated with lost opportunity.
He does not get hooked up at any boundary price of 35 Lacs, even if it means selling his real estate investment at a loss.
So, he offers a 2 Lacs discount and make the deal attractive. He is able to sell it off for 33 Lacs today.
He takes his 33 Lacs and re-invests the money @ 10% ROI in a mix of various investing options.
His returns after 1 Year = 33.00 Lacs + 3.3 Lacs (10% ROI on 33 Lacs) = 36.30 Lacs

Why does Case 2 give him higher returns?
It is because he was able to deal effectively with the cost of lost opportunity.
While he was waiting 1 year for the market price to come up, there was a lost opportunity to earn 10% ROI from some other alternative source.
This difference of 0.95 Lacs (36.30 Lacs - 35.35 Lacs) was his cost of waiting or cost of lost opportunity.This is a very common mistake investors do. 

Summary
Low Performing Assets in your portfolio must be continiously evaluated for Cost of Lost Opportunities. Your money has to work for you. You got to keep monitoring the performance of each Asset and making your portfolio earn better for you. You are the CEO of your portfolio and your Assets are your employees working hard for you. See non perforiming eployees? You know what needs to be done as a CEO.

Further Suggested Read

Your Assets are Your Employees

Regards

Manoj Arora
Official Website