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It’s Time to Quit

Controversial, I know. The only thing you hear nowadays is if you quit, you lose; winners never quit and quitters never win and so on, but ignore the people who tell you that; let me tell you why.

Evidently, no one has ever told these people about sunk costs and opportunity costs; the two most significant variables that should be taken in to consideration when making a decision or thinking about quitting. Let me explain:

1. Sunk cost:

“A cost that has already been incurred and thus cannot be recovered. Sunk costs are independent of any event that may occur in the future.”Investopedia

A sunk cost, in simple terms, is a cost that has already been incurred from a previous opportunity or decision that’s been made. This could include a financial investment made to start a part-time hair and beauty course or a gym membership subscription.

2. Opportunity Cost:

“The benefits you could have received by taking an alternative action.”Investopedia

An opportunity cost is essentially the cost of an opportunity or the missing of a benefit that may come from an alternative opportunity e.g. missing the benefit you may make if you started playing badminton instead of going to the gym or changing your course from a hair and beauty course to an accounting course.

The difference between these two variables is that, a sunk cost is backwards looking and the opportunity cost is  forwards looking. Secondly, a sunk cost is unavoidable, where an opportunity cost is avoidable.

In order to make a decision on if whether to quit or not, what you have to do, as the decision maker here, is to quantify, in some way, the difference between these two variables by understanding, which will offer the most benefit to you – either to keep on paying for something that you want to quit and not gaining maximum benefit from, or to gather benefit from another opportunity and quit whatever you’re doing now. You may have to be a little creative when quantifying benefits, as mostly, these won’t come in simple number or money terms; they could even be happiness, peace of mind or time saved.

Decision Maker: If the benefit from another opportunity outweighs the benefit from whatever you’re doing currently, then you should quit immediately.

I hope you will agree with me when I say, It’s not worth wasting precious resources like time, money, energy, your mental health on things that aren’t giving you the benefits you want.

Let me give you an example: You’ve just joined the gym and are paying £50 a month. The problem is that you hardly go because you’re so busy with work and commute long distances. The next thing is that, when you do go, which is once a week, you hate being there and find it a chore. You’ve now been paying £50 for three months and are thinking of quitting, but have some friends who say, the gym is good for your health and that you should keep going and only losers quit and so on.
You’ve been presented with an opportunity, where your neighbour has asked if you would like to join their badminton class for £50. You used to play badminton a couple of years ago and would enjoy the company and would find it less of a chore.
The costs and benefits between these two situations is as follows:

  1. You feel you would enjoy badminton more, as you used to play it before;*
  2. You would prefer the company, where in the gym it’s just yourself;*
  3. You may find yourself going more than once a week because you will probably enjoy badminton;*
  4. Both propositions cost the same (£50);*
  5. You can go to the gym on your own, whenever you feel like it;
  6. You find the gym a chore;*
  7. You hate going on your own* and
  8. You’ve paid £150 through you’re gym membership subscription already.

You’ll note that there’s no difference in cost and that you’ve already spent £150 on your gym membership, but that’s money gone and you can’t do anything about that – it’s a sunk cost.
Now, the logical, rational decision here should be to quit the gym. There are clearly more benefits achievable with badminton compared to the gym (which I’ve marked with asterisks above) and as a result, you will be achieving more value from your £50 investment. Sure, you’ve lost £150, but do you really feel like losing another £50 and so on by going to the gym because you’ve already invested £150? Common sense says, you should be a quitter and join your neighbour to play badminton.

This approach to decision-making is applicable to anything in life, both from your decision about your fitness, or to a financial decision. The question you really need to be asking yourself is, “is the new thing that I’m going to do, after quitting what I’m already doing, going to give me more value?” ‘Value’ can be anything from financial, emotional value or anything else. If ‘Yes’, then the sunk cost is irrelevant because it’s gone and you can’t get it back; it’s unavoidable. What is avoidable is how much you carry on spending on it by not quitting.

It’s time to quit.

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Getting the Record Straight about Opportunity Costs

So I met somebody the other day; let’s call him Ryan, who said something along the lines of, “I didn’t do it. I was suffering an opportunity cost, it would have taken up my time, so I got someone else do it; I outsourced it.” I said, “Oh okay, cool. So what did you do instead?” He responded with, “I went to the pub instead.” We then laughed together – it would have been rude if I didn’t, right?

Now the problem with ‘Opportunity Cost’ is that it’s a term banded about so much that the idea is sometimes misunderstood and therefore some may not use the idea properly as part of their decision making. I wasn’t even sure if Ryan properly understood what an opportunity cost was. Here’s a definition:

“A benefit, profit, or value of something that must be given up to acquire or achieve something else. Since every resource (land, money, time, etc.) can be put to alternative uses, every action, choice, or decision has an associated opportunity cost.

Opportunity costs are fundamental costs in economics, and are used in computing cost benefit analysis of a project. Such costs, however, are not recorded in the account books but are recognized in decision making by computing the cash outlays and their resulting profit or loss.” Source

So, according to the above definition, every action, choice or decision has an associated alternative and therefore, opportunity cost if it’s not taken. To further expand in my own words, an opportunity cost is the cost of something that was not accessible or doable, due to the resource that could capitalise on that opportunity being tied up elsewhere doing something else, therefore you are losing an opportunity and incurring a cost.

Back to our mate Ryan who paid to outsource a task to someone else for him to do because he suffered an ‘opportunity cost’ – the opportunity being, going to the pub.
What’s important to note is that, no matter what Ryan did, he would have always incurred an opportunity cost, as based on the above definition, there is always an alternative and therefore, there will always be a cost. The next most important decision criteria that can be used to prioritise opportunities however is understanding, which, out of those opportunities is the most value-adding.
Now if Ryan valued the opportunity of going pub more than the result of the task he outsourced more value-adding, then he certainly made the right decision and you should stop judging him here ;-).
Where however he used the opportunity cost as an excuse to outsource a task and not take up another opportunity that was equally or more value-adding than the one he outsourced, then he made the WRONG decision and suffered an opportunity cost.

It is an assumed objective that every resource should be appropriated and utilised to undertake the most value-adding activity he/she/it can. Where it isn’t, it is a waste of resource and therefore an opportunity cost is incurred because the resource could be capitalising on another more value-adding opportunity.

My opinion is that Ryan did suffer an opportunity cost, as I don’t see going to the pub as being that value-adding relative to what seemed like a business related task; he may think differently however.

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Investment Decision? Easy.

You may be in a situation where you need to make an investment decision. You’ll already know that one of the worst possible ideas you can have is to keep it in a bank; you’ll see from a previous post here, that keeping your money in the bank will probably leave you worse-off.
With this spare money, you, as a savvy money person, in theory should be looking for opportunities to grow your money to make your money grow; this could either be to gather a return 40 years down the line, or to gather a return 2 years down the line. In any event, the ultimate objective is to grow money and make it work for you, resulting in the creation of value. The opposite is worse-off by not using it properly and being subject to forces like inflation and interest rates.

I must start with a disclaimer that most investment opportunities come with risk. The underlying principle of risk is that the more risk you are asked to take, the more you should be rewarded for it; that’s why Government bonds are so low yielding – this is mainly because of their low-risk nature, relative to a business deal or stock opportunity. Risk even comes with keeping money in your bank, but the low return on your money suggests that a bank is also low risk. This is a good article that describes the risk-reward relationship in more detail. It is to be noted that everything comes with risk and in this article, I assume you are assessing risk relative to your risk appetite as required. If you’re not comfortable with an opportunity and it doesn’t “feel right”, then it’s too risky for you – simple!

So the three things to take into consideration when considering an investment opportunity are (in this order):

1. Return on Capital Employed
or “Return on Employed Capital”; “Return on Invested Capital”; “Return on Capital Invested”
The ROCE measure tells us what the percentage profit return is on the money we invest is i.e. the amount of profit a person makes as a percentage of their total money invested.
This is probably the most widely used measure used to determine an opportunity’s profitability. It takes in to consideration the income generated by the opportunity relative to the amount of money that is to be invested and presents this as a number in percentage terms.

What’s also important is that it is a percentage based measure; this allows us to compare the ROCE with other opportunities to see which is more profitable, irrespective of opportunity figures or size of investment. This is useful in the event you have two opportunities and don’t know which to invest in.

Ensure this figure beats your bank interest rate and inflation where possible. The higher this figure is, the better.

2. Time Value of Money
or “TVOM”
Okay, so with your ROCE measures in your hand from two opportunities (#1 & #2) for example, it’s now important to know how long it will take for your return from each opportunity to materialise. This is important because although ‘opportunity #1’ may offer an ROCE of 45% and ‘opportunity #2’, 30%, the time difference between these two opportunities may influence the investment decision.
Fathom this: ‘Opportunity #1’ will give you your initial investment + 45% return in 30 years and ‘opportunity #2’ a 30% ROCE in 10 years. Naturally, based on a quick back of envelope calculation, most people would go for ‘opportunity #2’ otherwise the investor may be waiting an extra 20 years for a further 15% return! Furthermore, if you break it down to a yearly basis, it would suggest ‘opportunity #2’ is more profitable across the project term, despite the lower ROCE! – this is why time period is important.
Anyway the real reason the measure of how long the opportunities will take to materialise a return is important is because (a) the longer it’s taking to get your money back, the more opportunities you may be missing to generate either an equal or higher return. Secondly, (b) as time progresses, the value of each pound tied up in both your initial investment and anticipated return is uncertain. The value of the pound may fluctuate and worst case, be worth less in the future than today – think of quantitative easing or inflation and these diminishing the value of the currency, therefore rendering that same pound less valuable in the future, not being able to buy the same amount of things as it can today. So the quicker the return, the better, because you can use money in your hands today, based on todays value to invest to either generate more money or buy more things instead of tomorrow’s uncertain value.

3. Opportunity Costs
And lastly, the opportunity cost. When investing in something, you’re tying money up in to something that you won’t have access to for a certain period of time, therefore where opportunities arise in that period and where the money is tied up, you won’t be able to capitalise on them because you don’t have the funds available, because they’re tied up! Or invested. So on this basis, it is always good practice to understand that, by investing in one of the two opportunities presented, what other opportunities you may be missing out on as a result. For example another opportunity, ‘opportunity #3’ for instance could be a lower returning opportunity that comes with less risk that might work in line with your investment objectives or risk appetite. It could even be similar return, but in a different project that you may know more about. In simple terms, it’s the consideration of any other opportunities that you will miss out on because the money is tied up elsewhere.

There are other things that could be taken in to consideration e.g. if the return is fixed or compound based or ensuring the level of reward is proportionate to the level of risk, but I think the above three measures enable any lay person to make a good, considered financial decision, enabling your money to make you richer.