The Hidden Costs of Investing
When it comes to investing, some costs are obvious. For example, when you buy a stock, the price you pay is the acquisition cost.
There are also carrying costs after the initial purchase. An example would be an ADR fee that you have to pay regularly to the bank that sponsored the ADR. And if you trade on margin, the interest you pay would also be a carrying cost. By the way, if you are short a dividend-paying stock, you are responsible for paying the dividend paid while you are short the stock.
The Costs Not Recorded on Paper
You can see these costs listed on your brokerage statement. But there are actually more implicit costs that you may not be aware of. They are opportunity costs.
Let’s use a simple example to illustrate.
Suppose you have $2,000 and you are deciding between two stocks, A and B, that you like equally.
Money you invest in Stock A is money you cannot invest in Stock B. Thus, if you invested $1,000 in Stock A, that’s $1,000 less that you could invest in Stock B.
Let’s say you do decide to split the money equally and invest $1,000 in A and $1,000 in B. After one year, A returns 10% and B returns 20%. In total, you made $300 ($100 + $200). However, if you had instead invested the entire $2,000 in B, you could have made $400. Thus, the opportunity cost of your decision was $100.
Weighing Your Choices
Of course, no one can make the perfect decision every time. It is a good risk-management tactic to diversify between two stocks rather than putting all eggs into one basket. However, the point is that as an investor, when considering whether to buy a stock or not, you should take into consideration what you could instead use the money for.
It’s not only a matter of a choice between two stocks. Instead of buying a stock, alternatively you could buy a bond, or an option, or a mutual fund. Heck, you could even use the money to buy cryptocurrency or gold coins. As you invest, you will face a lot of decisions, and you want to weigh all your choices.
It goes without saying that you want to pick the choice that you expect to give you the greatest return. But another factor to consider is liquidity. All things equal, being nimble is preferable. The faster you can convert an asset into cash, the quicker you can make adjustments and invest in something else.
Liquidity and Options
The power of liquidity can be seen even in when options are exercised. If you’ve written options, you may have experienced being put a stock before the expiration date. I would be surprised, however, if you’ve ever had a call option exercised against you before expiration.
In the first case, the counterparty—let’s call him Joe—sells the stock to you at the strike price. Joe exchanges shares for your cash. Joe can invest that cash in something else. The reason Joe decided to exercise the in-the-money put before expiration is that he believes he can make more money by selling you the stock now and reinvesting the cash into a more attractive asset than holding onto the shares until expiration.
In the second case, if Joe exercised early, he would be exchanging cash for shares, tying up the money in the stock. If he waited until expiration to exercise the call, in the interim he could have possibly invested that cash in something else in hopes of earning an extra return.
As you can see, the concept of opportunity cost figures prominently into Joe’s decision whether to exercise early. Joe is asking himself if he is better off if he did A or B. To increase your investing success, you should also routinely consider different alternatives and ask yourself if you are currently doing the best possible thing.
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