Wed 25 Oct 2006
Who: This post is for people looking for an economic twist to finance and for those who want to get an understanding of two fundamental economic and financial concepts.
What: This post will discuss opportunity cost and how to apply the theory in the real world. Also, this post will discuss the relationship between risk and reward and what it means for you. You can also read the other two posts in this series: ‘The Basics II: Responsibility and Psychology‘ and ‘The Basics I: Budgets and Fees‘
Alas, we come to the end of the 3 part series on the basic basics of finance. This will be the last formal post on the basics of finance, but many other posts will be labelled as basic if I feel that the concepts are relatively ubiquitous and fundamental. In this final post of the trilogy, we’ll be discussing concepts with an economic twist, but there won’t be any scary math, unless you click the wikipedia link below.
Before we move on, I wanted to present you with a chart. I assure you, this post will discontinue the trend in trilogies that you see below.
- When you sign Alex Rodriguez, you forego the opportunity to go to the world series.
- When you have Peyton Manning on your team, you forego the opportunity to develop any sort of running game.
- When you forget an anniversary, you forego many, many, many good things.
- When you invest in stock x, you forego the opportunity to invest in stock y AND the opportunity to invest in a risk-free (almost) investment.
- When you make an extra payment on the mortgage, you forego the opportunity to invest it in stock x.
- When you eat dinner out, you forego the opportunity to spend that money on an X-Box 360.
So, I think you get the picture. Why is opportunity cost important? Well, from the examples, we can see why it is important for the Yankees, but why is it important for you? Remember that every decision you make prevents you from doing something else, in a sense. If you spend $5 on a Big Mac, then it prevents you from spending THAT $5 on a Whopper.
When dealing with personal finance issues, it is always important to keep in mind that you should not be comparing possible time and money investment options against returns of 0%. You should always be comparing options with what you could be doing with your funds/time.
For a good application of this concept, check out the Time Value of Money post.
2) Risk/Reward - There are a lot of golden rules, and a lot of people make up their own, so I will make up my own. But I will call this the platinum rule: It is exceedingly rare that you will ever find an opportunity which has a risk that is not commensurate with its expected return.
- Huh? - Basically, what I am trying to say is that if you find an investment or opportunity that is rock-solid and very safe, you’re not going to find a stellar return from it. Conversely, if you find an explosive opportunity for growth and gain, then you can bet that the risk level is going to be significantly higher than the risk associated with the rock-solid opportunity. If you think you have found a scenario where the risk is disproportionately low compared to the reward, proceed with extreme caution and skepticism.
- No Clear Cut Answers - There are no clear cut decisions about what kind of risk to accept and what kind of risk to not accept. Your time horizons, your aversion to risk, and a variety of other factors will determine your propensity to take risks. Some people are risky, some people aren’t. If you’re young, you’ve got a little more room to take chances while if you’re close to retirement, you don’t have that luxury, for example.
- How to Measure Risk/Reward - There are a lot of objective (and subjective) ways to measure the risk/reward of any given opportunity. My favorite (and simplest, not necessarily best) method is the Sharpe Ratio. I’ll have a little discussion on it in a future post, but it is a basic measure of the reward to risk ratio of an investment. The higher, the better the ratio is for you.
- Investing 102: Creating Your Allocation
- The Time Value of Money
- The Basics II: Responsibility and Psychology
- The Basics I: Budgets and Fees
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