Most investors think of risk as the potential to lose money in an investment. However, there is more to risk than the possibility of loss.
It is what economists and business analysts call opportunity costs.
Opportunity cost simply is the loss or price you pay for making one decision as opposed to another. It is important to acknowledge these costs because to not do so distorts the economics of a decision.
For investors, the opportunity cost might be keeping your cash in a relatively secure savings instrument or investing the money.
If you decide to sit on your cash in a savings instrument, your opportunity cost is the gain you will not realize by investing instead.
You have to look at each decision both ways. So, the opportunity cost of investing is the interest you would not receive if you had put your cash into a savings instrument.
If the stock goes up after you buy, it may gain more than any interest you could have earned with your money in a savings instrument.
If the stock goes down, you have lost not only value in the investment, but the interest you could have earned by putting your money in a savings instrument.
For example, you could invest $10,000 in a stock or put the money in a savings instrument paying 2 percent interest.
Two percent of $10,000 is roughly $200 (we’ll ignore compounding, taxes, etc., to keep the math simple).
If you chose to buy the stock instead of putting the money in savings, your investment would have to earn more than this to offset the opportunity cost of making an almost certain $200.
If the stock declines in value by $300, for example, your loss is $500 ($300 in the value of the stock and $200 in interest you did not earn because the money was invested).
What is the risk that the investment would not make this threshold? If the risk is high that the investment would not earn this much (or lose money), the opportunity cost would be too high. You could have done better with the savings instrument.
However, if you perceive that the market is poised for a big gain, sitting on a savings account would be more costly than investing; that is, the opportunity cost of choosing the safety of savings would be too high.
You should always be concerned about the risk of losing money. However, playing it too safe carries a cost also.
