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Opportunity cost knocks

18 February 2016

Russell Harrop, Head of International Equities

Decisions, decisions, decisions. The vast majority of the time we just take them without even thinking about it; indeed almost all are so small or commonplace that we couldn’t even tell anyone that we had. This is hardly surprising, given that we are believed to make 10,000 decisions every day. Author and economist, Noreena Hertz, states in her essay ‘Decisions’ from Vestra’s essay series in partnership with The School of Life, that ‘we make 10,000 decisions every day, 277 just about food’. Based on eight hours sleep, that’s a new decision every 6 seconds. Ouch. With such numbers we’re bound to get many wrong, but how can we make sure more of them are right?

Have you ever sat down and thought about how you make decisions? Think about it now. You’ll probably say it depends on what the decision is, how important it is and how quickly you need to make it. Fine, but what about making a big decision? Do you have a decision-making process?

Let’s assume you still have your £15,240 2015/16 tax-free Individual Savings Account (ISA) allowance and have the money ready to invest. Perhaps you look at the financial press and compare the best UK income funds. You choose the best fund over the past three years, fill in the form and transfer the funds. Job done. You considered the alternatives and made a decision so you mentally pat yourself on the back. Hmmm. You really should have wagged a metaphorical finger at yourself. You’ve done what the vast majority of us have done by looking at a list of options and making a decision, but you’ve completely forgotten that in reality everything is at least twice as expensive as it appears.

Bonkers, you think? Not at all. In every decision there’s a cost, but there’s also a hidden cost. The opportunity cost. That’s the lost opportunities of all the other options you could have taken instead. When you buy a car, you may well be automatically giving up the opportunity to get a new kitchen, or perhaps a dream holiday. With 10,000 decisions a day, we can’t possibly explore all of the options for every decision, but when it comes to the really important ones we owe it to ourselves to think about the total cost of that decision. The cost, plus the opportunity cost(s).

To return to the ISA. You may have made the right decision, but unless you’ve considered what else you’ve given up you can never know. Perhaps the fund continues to do well and grows 5% per annum for the next ten years, increasing your £15,240 by an impressive £9,584. Good work, it seems, except it turns out that the fund manager had just left when you bought and his new fund grows by 8% per annum. Your ‘good’ decision has actually ‘cost’ you the extra £8,078 you could have made by following the fund manager.

As the investment experts here at Vestra, we cannot be sure of the future, but we can help to assess your opportunity costs.

Through Vestra’s partnership with The School of Life, Noreena Hertz, author and economist, has written an essay on the decision making process, please click here to read it.