Understanding Opportunity Cost and Return on Equity
As an investor, it is critical that you understand what opportunity cost and return on equity really mean. Understanding is the difference between success and failure.
You may think that opportunity cost equates to “non-existent” numbers, but I’m here to show you exactly why you can consider them to be as real as actual losses.
Essentially, opportunity cost means this: the loss of potential gain from other alternatives, when one alternative is chosen.
To make it simple, here’s an example. Idle cash balances represent an opportunity cost in terms of lost interest. If your dollars are dong one thing, there is a potential cost for what your dollars could have earned elsewhere.
As an investor, opportunity cost is always at play, because you’re always making decisions about two things.
1. Where to warehouse your cash
2. Where to invest your cash
So when you invest (or store) your money in one place, you lose all the opportunities you didn’t choose. This can have big consequences.
Return on Equity
Most investors understand return on investment really, really well. They have to. But what about a return on equity?
The return on equity in a house, or other real estate property, is always zero. So the opportunity cost with a fully paid off house, for example, is huge. Whether it’s your personal residence or a different property, the equity is not earning you any interest.
But let’s think about it in a different way. Let’s say you have $1 million, and you invest 80% of that capital in an investment that pays you 10%. So you’re earning $80,000 annually on your $800,000 investment. That’s a great return, but what happens to the $200,000 that you didn’t invest?
Nothing. It stays as it is. Which is fine, but let’s consider the alternative.
Let’s say you took that leftover money and put it somewhere that’s earning 4%. You’re not investing, but you’re not letting it sit there either. Suddenly, you have an extra $8,000 in your overall portfolio, rather than keeping it idle.
Putting it Together
If you look at this million dollar portfolio as a whole, you can see how return on equity and opportunity cost work together in harmony.
Because if you had simply invested your 80%, you’d have a solid $80,000 annual return. But by moving your remaining capital from a bucket where it was earning nothing, to a bucket that earned 4%, you turned your $80k profit into $88k.
The reverse? If you let your $200,000 sit idly by, you would effectively lose out on a potential $8,000 a year.
It’s not just a theoretical loss, it’s a real cost.
Building Your Strategy
My hope is that, as you go forward, you’ll begin to see opportunities everywhere. Especially when it comes to the money that you don’t have invested. Because here’s the thing — you may not be taking a tangible loss, but if you’re only thinking about it tangibly, you’re losing the game.
Live your Freedom, Live Your Legacy, On Your Own Terms,
M.C. Laubscher is a husband, dad, podcaster & Cashflow Specialist. He helps business owners and investors create, recover, warehouse & multiply cashflow. You can learn more about exclusive cash flow strategies in M.C.’s new video series at https://www.yourownbankingsystem.com/