We have heard many people talk about opportunity costs these days. The opportunity cost for your investment basically means what you give up from making a choice. For instance, you may take a less risky investment but give up to get a high dividend yield.
Opportunity cost can be different for different people. Your opportunity cost is highly affected by your financial resources, temperament, trading experience, age, and personal situation.
Examining opportunity cost can give a significant effect for your net worth to generate passive income and be financially independent. Here are the ways to apply it to your investment.
1. Assess the Liquidity Opportunity Cost
The biggest liquidity opportunity cost is when you have to miss an investment opportunity only because you can not get your hands on your money. For instance, you have two investment choice, one requires you to tie up money for 3 years and the other one 10 years.
If you think that the interest rates will go down in the near future, then the 10 years investment is a better choice. But, if you think that the interest rates will rise, then choose the three years investment.
2. Compare the Opportunity Cost between Investing and Spending
Your money worth is in the things that it brings for you. If spending money does not bring you good products or services, then your money is practically worthless.
Always ask yourself, is it the time to spend money, or is it the time to put it in assets that generate interest or dividends? That question is highly personal. It comes down to your very own value. No one can define that value for you.
This way, you can exercise your awareness in making a decision. Make sure that you do not sacrifice what you need from what you want. For example, if you are a medical student, you have to choose to buy a pocketbook or your investment.
3. Assess the Opportunity Cost for Each of Your Asset
You have to be aware that each asset allocation in your portfolio has its own opportunity cost. In history, investing in bonds give investors a lesser return than investing in the stock market. Yet, the stock market has a bigger price fluctuation.
On the other hand, bonds can be safer, yet it gives you a lesser profit. No matter what you choose, there always be an opportunity cost. We will never have a perfect investment with a zero risk.
