The Ignored Costs of Capital
Do you know how time value and the macro-economy work against your ROI? Most investments are measured exclusively by their annualized return. A positive return is the most sought after upside to an investment but it must be remembered that maximizing profit and minimizing cost are the exact same thing. As an intelligent investor, you must understand what factors may be limiting you from growing your capital as much as possible. The obvious costs of capital include interest rates and financing costs.
Beyond these common costs, there are other economic forces working hard to ensure that your money may not be working as effectively as possible. These forces are the ignored costs of capital.
It’s easy to analyze the effect of rising prices, simply look at any Inflation Index chart from Statistics Canada and you will see rates of about 1% up to 12% annual price inflation over the last fifty years. When most people imagine the effects of inflation, their primary concern is that the prices of goods and services are rising. While this may seem to be the case, this explanation doesn’t capture the true effect that inflation has on a market. The intelligent investor sees inflation not as a growth in prices, but as
decrease in buying power of every dollar in the economy. It’s not that goods and services are becoming more expensive, it’s that your dollar now buys less than it did before. This deeper understanding can help explain the causes of expansionary trends but more importantly, grants insight to the effect that inflation has on your investments. Because every dollar is losing its buying power every year, every percentage of return that your investments earn, inflation cuts down the net gain. Think back to 2018. What was your overall average portfolio return? The October equities market selloff placed most ETFs and Index Funds at breakeven or even negative return levels for the year. This seems bad enough, but factor in the systematic cost of the macro-economy and inflation devalues that losing portfolio even further. The intelligent investor recognizes that a poor year for returns can be discounted to equal little or no return once inflationary trends are considered.
In economics, opportunity cost is considered to be the cost of choosing one particular investment over the next best alternative. For example, if you bought into an Index Fund expecting to grow at 6% annually, then the opportunity cost of that decision would be the expected return of the fund that you didn’t choose to invest with. It can be thought of as a type of sacrifice you make with your capital on hand. If you allocate it in one direction, it is no longer able to work in the opposite direction. If we had infinite capital of course we all would try and maximize returns by investing in every fund possible and minimize the downside opportunity cost. But, capital is a scarce resource so we must pick and choose carefully where it is placed. But you must allocate your capital efficiently, which means not letting it sit idle. Quantitative finance assumes that all investments have a minimum rate of return equal to the yield of a current government risk free bond. This means that the value of money for every year it is not at work can be discounted by the current annual yield of the risk free bond. The 2018 average yield for one-year Canadian government bonds was about 1.6% annually. This means that every dollar sitting idle as cash in 2018 is costing you 1.6% a year in lost opportunity value. Don’t let your money lose its value by sitting idle. Allocate it efficiently and make it work for you.
While depreciation is not a direct cost to capital, it does cause an overall decrease in the book value of your holdings. There are many ways to account for depreciation, the main characteristic of the most common methods is time, usually running time or age of the asset. As an asset fulfills its lifespan, its value is discounted annually based on what type of asset it is. Buildings are usually discounted at a rate of 4% annually while vehicles and machinery can lose as much as 30% of their book value every year. Be
wary of how a firm discounts depreciation from the value of assets, not all methods give the same answer. The benefit of depreciation is that is accepted by CRA as a cost and is able to be claimed under a cost allowance. This helps partially mitigate the cost of depreciating assets but the refund is only a percentage of the asset value lost. It is important to understand how this generalized loss of value may affect your investments.
The traditional business thinks about the cost of capital as equalling the amount of return required to break even on a venture. The factors often left out of financial and accounting statements include inflation and opportunity cost. Depreciation is recognized in most accounting methods as being a cost but is rarely included in analysis for investments. Typically, these costs on a businesses’ capital are ignored as they represent a force that is effecting the market as a whole. For the individual investor, inflation and opportunity cost represent stifled returns and delayed growth. Similarly, depreciation works against the value of already held assets. In order to protect yourself, build a portfolio that creates value regardless of the volatility of the economy at large and commit so you don’t waste your money’s time. A reliable return is the best return. Entrust your portfolio with people that have a proven record and responsible management. Enable your money to make the most for you.