When we talk of investment risks, there are quite a few risks that we are familiar with. For example, equities run the risk of volatility while bonds run the interest rate risk. Corporate FDs run the risk of default by the issuers while asset classes like gold run the risk of global factors. But are you aware of the biggest risk of all? It is the “risk of not taking any risk”. There are two ways to look at risk. One way to look at risk is to look at it as a necessary evil which needs to be managed. A more proactive way of looking at risk is as a leverage which you can use to earn higher returns in the long run. When you are young and invest all your money in debt, there is huge opportunity that you are losing out. When you are just 25 years old, you have many years of earnings ahead of you and putting all your money in a liquid fund would be a waste of your risk taking capacity. That is an opportunity loss.
What does an opportunity cost mean? It is the cost of an opportunity lost. Let us understand the opportunity cost of not investing or not investing appropriately. How to calculate opportunity cost of such decisions? You can best do it be making a comparison. Remember, opportunity cost and investment decisions have a major bearing on your long term wealth accumulation. Let us see the 3 types of opportunity costs that investor incur..
1. Not starting early – Missing out on the compounding advantage
This is one of the biggest opportunity losses in investing. It is said that the earlier you start, the longer you stay invested. That means not only does your principal compound more returns but even your returns compound more returns. That is why it is always ideal to start as early as possible. Adopt a SIP approach and ensure that you continue to invest in return generating assets for a long time. The power of compounding will automatically work in your favour.
Let us delve into this idea with the case of Ashok and Anil. Ashok was a long term thinker and decided to start saving for his retirement at the age of 25 itself. His logic was that he would squeeze the most out of his current income and invest in equity funds. Anil, on the other hand, wanted to enjoy his younger years. He decided to start his investment game later but with a much higher investment outlay. How will they fare at the time of retirement? Check the comparison
ParticularsAshok’s SIP InvestmentAnil’s SIP investmentSIP started at the age of2545Continues SIP till the age of6060Monthly SIPRs.5,000Rs.20,000Invested SIP inEquity FundsEquity FundsYield on Equity Funds14%14%Actual amount investedRs.21.00 lakhsRs.36.00 lakhsAmount accumulatedRs.5.62 croreRs.1.23 croreWealth Ratio26.8 times3.4 times
The above table is quite instructive. Ashok, despite investing just Rs.5,000 per month and a total outlay of just Rs.21 lakhs, is able to accumulate Rs.5.62 crore at the time of retirement. Anil, on the other hand, starts with a monthly SIP of Rs.20,000 and has a total outlay of Rs.36 lakhs but is yet able to accumulate a corpus of just Rs.1.23 crore at the time of retirement. The difference is all about starting early. The lower corpus is the opportunity cost that Anil has paid for starting his investment plan a tad too late.
2. Conservatively ignoring equities – Missing out on the wealth creation advantage
Losing out on time is one side of the story; the real challenge is the asset class you select. Ideally, when you have a time frame of 30 years ahead of you, then you should prefer equities. It has been proved that if you hold equities for more than 8 years at a stretch via diversified funds then your risk of downside is almost zero. If you put your long term funds in very safe debt assets then you are losing out on the opportunity to create wealth. Let us see this difference with a practical illustration. Let us assume that in the above illustration Ashok had done a SIP on a liquid plus fund rather than an equity fund. How would it look?
ParticularsAshok’s Equity SIPAshok’s Liquid Plus SIPSIP started at the age of2525Continues SIP till the age of6060Monthly SIPRs.5,000Rs.5,000Invested SIP inEquity FundsLiquid Plus FundsYield on Equity Funds14%7%Actual amount investedRs.21.00 lakhsRs.21.00 lakhsAmount accumulatedRs.5.62 croreRs.90.58 lakhsWealth Ratio26.8 times4.3 times
The above table underscores the importance of investing in the right asset class. If Ashok had invested in liquid funds instead of equity funds, then his principal may have been very safe but he would have lost out in the process of wealth creation. With 35 years of investment ahead of you, putting all your money in a liquid fund is a waste of your risk taking capacity. The opportunity cost is nearly Rs.4.7 crore.
3. Not allocating assets – Missing out on the rebalancing opportunity
This is a unique kind of opportunity cost that we tend to miss out on a very pragmatic level. One of the purposes of asset allocation is to ensure that you automatically keep churning profits when the asset class becomes overheated. If your original allocation to equities is 50% and due to a bull run it has gone up to 65%, then it is time for a course correction and reallocation back to targeted levels. If you miss out on this reallocation opportunity, there is a huge opportunity cost you bear of being in the wrong asset class at the wrong time and not having enough liquidity when it is time to buy.
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