Opportunity Costs
College, or work? Pizza, or stock?
by Brian Graney (TMF [email protected])
ALEXANDRIA, VA (Oct. 12, 1998) -- Since I'm just beginning with this investing stuff, I don't have any terrible stock misfortunes to speak of. Except one: I may have just witnessed the best three consecutive years for investment performance that I will ever see in my lifetime. As the years 1995, 1996, and 1997 are gone forever, so too are the 33.4%, 23%, and 37.6% annual returns of the S&P 500 index that went with them. Instead of investing during three of the most dramatic growth years which the benchmark index has ever seen, I was busy doing other stupid things, such as studying in France, graduating from college, and getting my first job.
In economics, life's little trade-offs are quantified as opportunity costs. For instance, by not going to work right after high school, I sacrificed four years of earnings for something called college. The opportunity cost of that decision is the four lost years of earnings, which could have included regular amounts of those wages being placed in a Foolish investment vehicle, such as an S&P 500 index fund. Under this scenario, I could have used that simple index fund to benefit from those whopping annual returns in '95 through '97.
What did college give me instead? At first glance, it seems I gained insight into what caused World War I and other historical factoids. And while my degree enabled me to start my wage-earning life on a higher rung on the salary ladder than the typical high school grad, I was also saddled with a whole lot of student loan debt. Great.
However, I'm hoping I will come out ahead in the opportunity cost race over time. While I sacrificed four years of probably minimum wage-level salaries and all of the related benefits, I gained an education and the higher earning potential that comes with it. Over a decent length of time, the monetary value of the former should end up outweighing that of the latter. If not, I wasted more time and money in college than I initially thought. (Sorry, Mom and Dad.)
Not surprisingly, the same idea holds true for stocks as well. Even if you missed the nice gains made by the S&P 500 over the last three years, that doesn't mean you have missed the entire investing boat. It's easy to reflect and say to yourself, "Gee, if I had only invested $1,000 in an S&P 500 index fund three years ago, look at the (paper) gain I would have now." It's much more challenging to think ahead and say, "Gee, if I only invest this $1,000 in the DRP of a well-chosen industry leader today, think of the (again, paper) gain I will have in 20 years." Those that can train themselves to think ahead are the world's true investors. Those that can only look backwards are called technical analysts and spend their days looking at the past for hints of the future.
The point here is to emphasize yet again the time element involved in investing. For someone such as myself on the verge of making his first investment (which will be in the DRP of a well-chosen, industry leader, by the way), the concept of opportunity cost is especially significant. Every dollar that I put into a DRP now will hopefully become several more dollars down the road, through the wonders of business growth, compounding interest, and reinvested dividends. On the other hand, I will lose those extra dollars in the future if I instead place that same dollar in an investment generating a significantly smaller return than that DRP, such as a pizza or a ticket to a Washington Redskins game.
Like a bad Yugo without its first three gears, it is much simpler for investors to drive in reverse rather than forward. This is because the past is known, but the future is unknown and unpredictable. But new investors must try to look past what has already happened. If you missed "the big stock market run-up" over the past three years, so what? It's history -- put a fork in those stock market performance tables and chuck them into a dark closet along with other momentos from yester-year, such as your high school letter jacket and your kindergarten graduation diploma.
Instead, focus on what you can do in the present. Leave history to the historians and let the future take care of itself. The opportunity costs of not doing so are much too great for a young investor. Later this week, I'll provide a real world example of how the concept of opportunity cost in relation to DRPs can hurt investors, especially the young ones.
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