Don’t you hate it when you realize, in hindsight, that you missed out on returns from a high-flying investment?
Plenty of people get wistful, thinking they could have bought Amazon.com Inc. (ticker: AMZN) in 1997 and hung onto it. But few people even knew what Amazon was at the time of its initial public offering, and many who did scoffed at the idea of selling books online.
While it’s usually impossible to catch one of those big winners early, and then hang onto it even as it goes through inevitable corrections, it’s crucial to consider what’s known as opportunity cost. That’s a potential loss of an advantage, such as a monetary gain, when choosing one option over another in investing or decision-making.
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Here are some ways that investors can minimize opportunity cost in their portfolios:
— Understand the role of cash.
— Diversify your portfolio.
— Monitor your accounts.
— Move your 401(k) when you leave a job.
— Avoid timing the market.
Understand the Role of Cash
It’s important to hit just the right balance when it comes to cash. Having an easy-to-access emergency fund is a good practice. However, holding too much cash in your retirement or brokerage account because you’re wary of the stock market presents its own risks.
“Cash reserves allow you to take advantage of attractive investment opportunities as they happen,” says Clark Kendall, CEO of Kendall Capital in Rockville, Maryland.
He notes that market downturns or sudden drops in asset prices can present excellent opportunities to buy at discounted prices. “Having cash readily available lets you capitalize on these situations,” Kendall says.
But he also cautions that cash comes with an opportunity cost, as it typically yields low or no returns compared with other investments. It’s true that today’s money market accounts are delivering solid returns, by historical standards, but that won’t always be the case.
“By diversifying and allocating a portion of the portfolio to potentially higher-yielding assets, you can reduce the opportunity cost of holding too much cash,” Kendall says.
Diversify Your Portfolio
Portfolio diversification reduces opportunity cost by spreading investments across different assets, reducing reliance on a small number of stocks, and maximizing potential returns while simultaneously mitigating risks.
“Diversifying a portfolio means holding investments in different asset classes, industries or geographic regions,” explains Kendall.
He adds that this helps reduce concentration risk, where a significant portion of the portfolio is exposed to the performance of a single investment or a small number of investments.
“If a concentrated investment performs poorly, the overall portfolio’s performance could be heavily affected, leading to missed opportunities elsewhere,” he says.
“Diversifying your portfolio is like planting different crops. If one fails, others may thrive,” says James Allen, founder of Billpin.com in Los Angeles.
Asset class diversification, Allen says, “spreads risk and can increase overall returns compared to just planting one ‘crop.’ A diversified portfolio makes it less likely you’ll miss out on the highest-performing investments.”
Monitor Your Accounts
A surprisingly large number of investors simply “set and forget” their accounts, neglecting to check their holdings. When that happens, you run the risk of owning a stock, or perhaps a fund, that’s fallen sharply out of favor, dragging down your account value. You might also own investments that are too risky for this phase of your life, and which should be pared back.
“Ignoring retirement accounts is like letting weeds grow in your garden,” says Allen. “Eventually, they can choke out the plants.”
Forgetting about accounts, he adds, or not regularly reviewing investments, can lower returns and lead to losses over time.
“It’s important to monitor all accounts so you can make timely adjustments,” Allen says.
Michael Wagner, co-founder and chief operating officer of Omnia Family Wealth in Aventura, Florida, emphasizes the need for investors to monitor and rebalance portfolios as they age, or as their life situation changes.
“We all grow and mature and come to different points in our lives, so if you have an old 401(k) from your early 20s, it could be allocated in a very different way than you would be setting up a 401(k) today,” he says.
READ: 10 of the Best-Performing 401(k) Funds.
Move Your 401(k) When You Leave a Job
According to Capitalize, a firm that helps investors find and roll over old 401(k) accounts, the value of forgotten 401(k)s exceeded $1.65 trillion as of May 2023. Capitalize estimates there are 29.2 million forgotten or left-behind 401(k) accounts in the U.S. The company says the problem, which has existed for years, was exacerbated as more workers changed jobs during the “Great Resignation” of 2021 and 2022.
“The potential consequences of forgotten 401(k)s continue to be significant,” Capitalize said in a June 14 report. “In a worst-case scenario, an individual saver is at risk of missing out on several hundred thousand dollars in retirement savings from leaving behind 401(k)s throughout their career.”
Allen likens leaving a 401(k) with an old employer to “leaving luggage at a hotel you checked out of. It’s easy to forget and hard to manage later.”
It can sometimes be challenging to locate old 401(k)s, but Congress recently passed legislation to create a searchable database of retirement plans, set for launch in 2025.
Wagner notes that it’s better to roll an old 401(k) into an individual retirement account, or IRA.
Avoid Timing the Market
Market timing is the practice of trying to predict the best moments to buy or sell investments, based on anticipated price movements.
Investors attempt market timing for several reasons, including fear, greed, impatience, misunderstanding of how markets work and simply the thrill of trading.
The opportunity costs of market timing lie in potential losses or missed gains. Attempting to time the market can lead to suboptimal returns, as it’s challenging to consistently predict price movements with accuracy.
Peter Earle, an economist at the American Institute for Economic Research, says, “It’s essentially impossible, outside of sheer randomness, to enter or exit a position at the precise top or bottom of the market.”
He adds, “Missing the worst days, weeks or months in a given time period nearly always means missing the better ones as well.”
He also points out that many 401(k) plans charge fees for entering and exiting the market, so on top of missing the best-performing days, investors may be paying hefty fees to miss them.
“It’s more about time in the market than timing the market,” says Wagner. “To think that you can be in and out of something and outsmart Wall Street is not an informed position to take, and people shouldn’t be doing it.”
More from U.S. News
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How to Reduce Investment Opportunity Cost originally appeared on usnews.com
