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Opportunity Costs

Jon Williams with Manulife Securities and Williams Financial Group.

Today, I’m going to talk to you about opportunity costs, and the impact that has on your portfolio.

So let’s talk about opportunity costs.

What exactly is an opportunity cost?

Opportunity costs according to economics, is the value of the best alternative foregone.

Specifically, I want to talk today about people maintaining large cash balances that they’re going to be using to fund their retirement. Because, from my perspective, the logical opportunity cost, of course would be the rate of return that the money would be receiving had it then invested properly. Not only that, there is a twofold opportunity cost from my perspective because the investors that are maintaining these cash balances are also losing money each year to inflation.

And I want to start off by talking a little bit about inflation. I’ll share a story with you about my grandfather. My grandfather retired from Caminco back in 1969. And when he retired, back then they used to have pension plans, very attractive ones, wherein if you work there for your whole life, you have 70% of your income guaranteed for the rest of your life.

Now, one of the things this type of plan did not have was any indexing to inflation. And so throughout his retirement, 30 years later, in 1999, his lifestyle was dramatically different as to what he could afford and how he could afford to live, than when he originally retired. When he was originally retired they had a great lifestyle and they had to continually cut back as they were retired for longer. Now, most people aren’t going to have those types of pension plans today but in fact, they’re finding their own retirement and therefore, they are choosing how to invest in their portfolio. And like I said, people with large cash balances are losing money each year.

So let’s talk about the impact to inflation. Now, we’re going to take a look at a 30 year time span here, and I want to give an example of what would happen to the dollar value, to the purchasing power of my investments over a 30 year time period. Let’s say for instance, a investor has a hundred thousand dollars ($100,000) invested over a 30 year time period. And we’re going to start off with a 3% inflation rate and then we’re gonna talk about a 5% inflation rate. At 3%, inflation rate of a 30 year time period, the purchasing power, the real value of this hundred thousand dollars at a 3% inflation becomes $41,200. At a 5% inflation rate, the value of it, drops all the way down to $23,100.

Now you might be saying, “Jon, 5% is unrealistic.”

Well, as a matter of fact, interestingly enough, the inflation rate that my grandfather experienced while he was retired was an average of 5.34%.

So let’s bring this back to a real life example. Let’s say today, a person retired, and they’re getting a pension plan. Let’s say it’s an attractive pension plan of say $45,000 a year of retirement income. So what would the impact be if they experience the same inflation rate as my grandfather did when he retired. What if they experience the 5% inflation rate over 30 years? What does their income essentially drop to? It’s outstanding. It drops to just over $10,000 per year equivalent. I think you could see why my grandparents had to adjust their retirement income or their retirement lifestyle rather, so dramatically throughout retirement because they felt this equivalent drop but the dollar amount stayed the same inflationary every single year. And this is what’s happening to people today. They are holding again, a lot of cash in their retirement income, it’s not only that it’s not growing in their investments, they’re losing money each year to inflation. And I just thought, interestingly enough, what would the rate of return would have been for a portfolio, that hundred thousand dollar portfolio if they have actually invested it in over the same time period. After inflation, the investor would have made about 8.87%. So, not to say the retiree would necessarily have all of their money in this case the S&P500. But even if it was a balanced portfolio, obviously, they would be able to keep up with inflation and then some.

So thank you for your time today. If you have any questions feel free to go to our website or email us. Take care.