7. Allocate capital by opportunity cost
Should you pay off your debt or invest? Buy government bonds or common stock? Go with a fixed rate or interest-only mortgage? The answer to financial questions such as these should always be made based upon your expected opportunity cost.Here’s how it works: an investor looking to acquire real estate in an urban area could ask themselves several questions such as, “is the average home price for the area increasing at a rate faster than average household income? If so, are there demographic changes taking place such as a rapidly expanding, educated population base that will make it possible for the local economy to sustain higher asset prices? Will the property be cash-flow positive in the event of a substantial increase in interest rates? “What is my expected return on a rental-income basis, aside from anticipated price appreciation?” If the result of this self-subjected inquiry results in an expected return of 8 percent, yet you calculate the return available on U.S. Bank stock to be 13 percent, you should go with the latter. Likewise, if none of your potential investments seem to beat some sort of arbitrary threshold, say a real return of 10 percent or more, you should simply park your excess cash in U.S. Treasuries. (Note: This approach is only appropriate for an entrepreneurial investor who manages his or her own capital. For a vast majority of investors, simply buying index funds through a dollar cost averaging plan is going to result in superior returns.)
