One of the few useful concepts I learned whilst ploughing through three years of economics at university was that of opportunity cost, a term popularised by Austrian economist (naturally) Friedrich von Wieser.
Imagine you have $100,000 to invest and settle on three options; stuffing it under the mattress; a five year term deposit earning 3%; or Scentre Group (ASX: SCG) yielding 4.5%.
The mattress is clearly the worst option so you discard it. Investing in Scentre earns you a 4.5% yield compared with 3% in the term deposit, which sounds attractive. But you understand that the opportunity cost of that additional 1.5% is the risk you assume investing in a traded stock compared with a term deposit (see What to do when yield becomes expensive? Part 1).
By choosing one option, you automatically forgo the others. The opportunity cost is the value of the next best option to the one you chose.
This additional risk is easily recognised and understood. There is, however, an implicit cost to being invested in shares that many investors miss, one that can have a dramatic effect on your future returns.
The value of cash isn’t just in the returns you might get from a term deposit or cash management account. The ability to quickly pounce on opportunities can be far more significant. Ready access to cash increases your chances of buying stocks cheaply. And as we know, that’s the biggest determinant of future returns.
Of course, you might be happy to be fully invested, ploughing into supposedly safe stocks like Scentre, acknowledging that if better opportunities emerge you may have to sell it to release funds to take advantage of them.
But that, too, has a cost. Not only would you pay brokerage on the way in and out, and potentially wear a loss on the trade, you also have to wrestle with the commitment principle. Because it’s far harder to sell something we’ve already purchased than not buying it in the first place, you may miss the opportunity altogether.
At a time when bond rates are at historical lows and yield has become relatively expensive, too many investors are forgetting the value of cash. The interest may be pitiful but the power of quickly adding a few bargains to your portfolio is potentially priceless.