Do You Know Your Opportunity Costs When Investing? Here’s A Deep Dive

In a earlier article of mine, I discussed the concept of opportunity costs when investing. In this article, I want to go even deeper into the concept.

As highlighted in my aforementioned earlier article, a default choice of investing $10,000 in an exchange-traded fund tracking the Straits Times Index (SGX: ^STI) eight years ago would have netted you a gain of around $5,700 today. This $5,700 gain would only be your opportunity cost if your other choice was to do nothing but keep the $10,000 in a bank with a basic savings rate of 0.2%.

Let us scope out various basic investment opportunities we have in Singapore and analyse how our opportunity costs would look like.

Ideally, salaried employees are maintaining a salary account that comes with bonus interest. Based on what’s available in the market right now, this means accruing interest of 2% to 3%, up to an amount of $60,000 or $100,000. So let us assume that we can achieve a return of 2.5% per year on our first $60,000. Beyond this threshold, any money in that account would only accrue interest of 0.2%.

Yet, every Singaporean can subscribe to the Singapore Savings Bond (“SSB”) for up to $100,000. The current first-year interest rate on a SSB is between 1% to 1.5% per year. The notional amount to “invest” in the SSB is $500, and we can redeem the bond at any time and still receive interest unlike a fixed deposit account with a bank.

Suppose Xiao Ming has $30,000 in his salary account and his mother has given him $30,000 to invest with. He has decided on two choices: (1) Invest everything in the Straits Times Index, or (2) leave it in his salary account. The Straits Times Index’s total return (including dividends) since 2010 has been around 5.8% per year, as alluded to earlier, and his salary account pays him 2.5%. His opportunity cost of not investing in the Straits Times Index is thus 5.8% – 2.5%, or 3.3%.

Compare this with Faizal, who has $100,000 in his salary account and is looking to invest $30,000 as well. His salary account will only pay him 0.2% interest on any amount above $60,000, and so it’s clear that he has already exceeded the threshold. If Faizal wants to choose between investing in the Straits Times Index and a risk-free alternative, the next best option would be the SSB that pays about 1.5% for the first year. His opportunity cost for not investing in the Straits Times Index would be 5.8% – 1.5%, or 4.3%.

The point is this. You can only measure your opportunity cost by your actual choices, not imaginary ones. I have a particular friend who measures investment opportunities by comparing their returns to a local bank that has done outstandingly well. He uses his winning investment as a benchmark in screening other company’s shares. When I asked him if he would consider placing capital that he has reserved for investing into the bank, he said he would not because he believes in diversifying his risks.

This is a mistake. When we measure the opportunity cost of making a choice or not making one, the only relevant costs to consider must be the choices we are willing to make. In my friend’s case, since he’s not willing to invest in the bank, the bank’s return should not be his opportunity-cost-benchmark.

To keep up to date with what's exactly happening in today's market, click here now for your FREE subscription to Take Stock Singapore, The Motley Fool's free investing newsletter. Take Stock Singapore can also show how you can GROW your wealth in the years ahead.

Like us on Facebook  to keep up-to-date with our latest news and articles. The Motley Fool's purpose is to help the world invest, better.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.