Investing and opportunity costs

I don’t think investing is all that hard, but you need to pay attention to what economists call opportunity costs. In this context, opportunity costs derive from failing to realize income that you otherwise may have enjoyed.

Consider the case of an investor faced with two investment alternatives, one yielding 5% and the other yielding 6%. All else being equal, it should be obvious that the correct choice would be to buy the higher yielding asset. Were you to choose the lower yielding asset, you’d be giving up that extra 1% of earnings. Hence, your opportunity cost would be the dollars forgone by choosing the lower yielding asset. One problem with this calculation, however, is that it assumes full information.

Clearly, we can’t necessarily expect everyone to be aware of all possible investment alternatives. In this case, for example, had there been a third investment opportunity available with an even higher yield, the opportunity cost for the person choosing the 5%-yielding asset would be even greater. On the basis of this consideration, many calculated measures of opportunity cost may actually understate the reality. Beyond that, the assumption, “all else being equal” is problematic. Different asset classes have different kinds of risks, making direct comparisons difficult. A comparison of stocks versus bonds is a classic case where opportunity costs can be considerable, while at the same time being difficult to measure with certainty.

Best practice requires comparing the expected returns of stocks to those of bonds, but assessing and quantifying the expected returns for these asset classes requires a certain amount of guess work. We can have reasonable confidence that stocks will outperform bonds over, say, a 10-year period; but it’s hard to be particularly confident about any explicit numerical value for the expected rate return that we might come up with. The best we can do is pick a number that seems consistent with experience, but over exactly what horizon? You’ll get different answers depending on how far back your sample extends.

I’ve looked at annual returns for the S&P 500 total return index over the 1930 -2022 period. The average of the annual returns over that entire period was 11.6%, with a maximum return of 54.0% (1933) and a minimum return of -43.3% (1931). Comparable statistics using rolling 10-year averages of annual returns show an average return for all such 10-year periods of 12.3%, a maximum of 21.5% (10-years ending 1958), and a minimum of 0.7% (10-years ending 2008). Given this history, it should be clear that we shouldn’t expect any estimate of expected returns be a particularly accurate predictor.

Some degree of uncertainty applies to expected returns for bonds, as well, but to a much more limited extent. With bonds, besides the coupon rate of interest, realized returns depend on the rate at which interest payments received during the life of the bond are reinvested — something that varies depending on ever-changing market conditions.

For the sake of an example, suppose we’re interested in examining the opportunity cost of holding bonds with a 10-year investment horizon. Intending to be overly conservative, I’ll assume expected returns for stocks and bonds to be 8% and 5%, respectively, over the coming 10-year period. If realized, a $1,000 investment would grow the bonds to a value of $1,629 after 10 years, while the stocks would be worth $2,159. The difference, $2,159 — $1,629 = $530. This amount would be the opportunity cost of holding the bonds over the 10-year period for each $1,000 invested. It should be obvious that the saver who is making a stock/bond allocation year after year as he or she puts money away for retirement — i.e., funds dedicated to a long-term holding period — would be making a serious financial sacrifice by being overly parsimonious in his or her stock purchases.

This calculation isn’t intended to say that stocks are necessarily the better investment choice simply because they’re expected to generate higher returns. A mix of stocks and bonds mitigates the prospect that circumstances could force you to liquidate stocks during a temporary downturn and forfeit the chance to recoup those losses when a bull market returns. My own view, however, is that if you’re fortunate enough to be able to have money that can be saved for a sufficiently long time (i.e., something on the order of eight to ten years or more), virtually all those long-term funds belong in stocks — and then pray that stocks deliver on the promise of being the outperforming asset class during that time. There are no guarantees, but it certainly seems to be both a smart bet and one consistent with conventional wisdom.