Investment and Opportunity Cost (Part I)

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Investing is fundamental to wealth growth and being able to invest wisely is very crucial. However, for every investment made, there most times exists an alternative forgone. This is referred to as the opportunity cost of making that investment choice.

The opportunity cost can be seen as the value that investors forgo by choosing a particular course of action.

The benefits you could have received by taking an alternative action becomes the opportunity cost of the action you choose to take.

For instance, the opportunity cost of taking a bus to work is the money you will save if you took a walk with an old time pal. On the one hand, you gain 20 minutes of catching up and acquainting plus the amount saved by walking; on the other hand, you lose an amount equal to the bus fare while getting to work faster (in 7 minutes).

Therefore, if you choose to take the bus, then you forgo the benefits of walking (saving money and chatting with your pal), which is the opportunity cost of taking the bus and if you choose to walk then you forgo having to get to work faster (by the 7 minute bus ride), which is the opportunity cost of walking.

If we apply this principle to investing; then for every investment made, there should be a compensation equal to the value of the benefits forgone (i.e. The benefits you could have received if you chose to invest in something else).

This is where the topic of receiving interest comes in. Interest payments are designed to compensate the investor for the opportunity cost of choosing which ever investment option he is receiving interest for.

For example, a dollar saved today grows into a dollar plus interest tomorrow. So the higher the interest rate, the greater is the opportunity cost of spending the dollar (not investing).

Your money is of significant importance and how you choose to use it matters. Whether you choose to save, spend or invest, the ultimate goal should be to maximize its value.

With the exception of making donations, when it comes to investing or lending, you should be concerned about not getting a value less than that which you choose to invest. Even Warren Buffett (widely considered the most successful investor of the 20th century and the fourth richest man in the world as of march 2013) is very cautious about how and where he invests.

The key thing here is that every investor or lender has a right (and I emphasize the word right) to be compensated for foregoing other alternatives.

Having pointed this out, it is smart to scrutinize the financial statements of companies you choose to lend to. Key financial statements to be considered include, but are not limited, to the following: the balance sheet, the income statement and the statement of cash flows.

In subsequent posts, we will discuss the minute but crucial details every investor should be able to extract from the financial statements (mentioned above) of the borrowers he chooses to lend money to. In other words, we will point out to you what you should be able to look out for before signing the cheque.