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VALUE INSIGHT

Beware of hidden or opportunity costs

This concept can be applied to decisions we make with all the resources that we have which are scarce, including how we spend our time and money

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When we pollute, we reap all the immediate benefits, but the long-term costs are quite literally blown away to become someone else's problem.

I WAS at an event called Make Care Count last Saturday. Organised by the Association of Women for Action and Research (Aware), the event aimed to shine a spotlight on the financial burden of caregiving for older persons in Singapore: a burden that all too often falls upon women.

Aware's analysis of the Labour Force Survey showed that from 2016 to 2018, there was a marked 9 per cent increase - from 263,000 to 286,500 - in the number of women who cited family responsibilities as the main reason for being out of the labour force. These women make up more than 90 per cent of the people who are outside the labour force because of family responsibilities.

Caregiving has severe consequences on the retirement adequacy of family caregivers. With an ageing population, we can expect the need for caregiving to increase over time. Will these female caregivers who have no income or reduced income be able to save for their own future needs, against increasing odds of ageing into frailty and poorer health?

The event on Saturday was to gather recommendations from participants on how to get policymakers to recognise and so help alleviate the financial cost of caregiving that family caregivers bear. The event write-up said it was designed for anyone who believes in supporting caregivers now, before they become crippled by a lack of financial resources in the future.

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One of the panellists was Joanne Yoong, an applied economist working at the intersection of behavioural economics, health and financial decision-making, and socioeconomic development. She is currently a Visiting Associate Professor at the National University of Singapore's Yong Loo Lin School of Medicine as well as senior economist and director at the Centre for Economic and Social Research East, University of Southern California.

In her opening address, Dr Yoong said that the field of economics is the study of resources, specifically how resources are allocated, and a core part of that is to understand the opportunity costs or the hidden costs of these decisions.

Personal costs

In the case of female caregivers, oftentimes they are the single and unmarried daughters. Because of the increased time spent on caregiving, that leads to several changes in their employment status, ranging from a reduction of working hours to complete withdrawal from the labour force. These changes in employment status are accompanied by a loss in personal income and CPF contributions. Not only do they not have income, their personal savings are being depleted due to care-related costs that have to be paid for out-of-pocket.

Besides personal costs to the caregivers, there are also costs to the broader economy as well. If not for caregiving responsibilities, some of these women would have more time to devote to, say, their businesses, which could create more jobs for the economy.

The idea of hidden or opportunity costs is a timely reminder for me as well. Because of the uncertainties in the macro environment, the valuations of many Asian stocks are rather depressed currently. We are seeing a number of stocks that have even more compelling valuations than those we currently own.

Unless we have constant flow of cash into the fund which we can deploy to the new stocks, we have to contend with the issue of how best to allocate the funds we currently have. That is where the concept of opportunity cost comes in. If we allocate our funds to stocks A, B and C, and as a basket, the probability of them delivering significant positive returns in the future is lower than stocks X, Y and Z, then that decision has a cost for the fund. We are sacrificing potentially higher returns by not doing anything.

Rationally and logically, we should reallocate the funds currently committed to A, B and C to X, Y and Z. But for many investors, this is not an easy thing to do. Many well-known psychological effects are at play.

For example, investors may form attachment to the stocks they already own, possibly because the stocks have done well in the past. In cases where stocks have done very well such that their current valuations are no longer cheap, then chances of them continuing to generate the returns chalked up in the past will be reduced.

On the flip side, if the stocks have not been doing well, there is fear of selling them now only to see them surge the next day, or the next week. In order to avert regret, many just do nothing.

How best then can we overcome these psychological barriers in order to construct an optimal portfolio?

For me, evidence- and rules-based approach work best. I need to see the evidence from empirical research that certain strategy, backed by sound fundamental reasoning, works. Once convinced, we'll devise rules to ensure that our process adhere to what studies show have worked over time. A rules-based approach will take quite a bit of mental load off each buy and sell decision. But trust me, even when we have rules which are backed up tonnes of evidence and research, there will still be doubts because each situation is slightly different. The key to strengthening one's conviction is to go through the process repeatedly, and to have experienced significantly more positive reinforcements than negative ones over time.

When it comes to allocation of funds, sometimes individuals may choose optimisation over maximisation. That is, opting for slightly lower returns for lower volatility, instead of going for the maximum possible return but at the risk of huge volatility. This is totally fine. One of the hidden costs of going for high risk and potentially high return option is the sleepless nights!

Allocation of resources

The concept of hidden or opportunity costs can be applied to decisions we make with all the resources that we have which are scarce, including how we spend our time, the money we want to spend, to donate, in fact many of our life choices.

Since economics is the study of allocation of resources, and the attendant costs involved in each of these decisions, why then have environmental costs of all our industrial decisions been ignored for so long?

Dr Yoong's explanation is that part of the reason why economists have not always included environmental costs is because:

  • They are very hard to quantify, so for that reason in many cases we ignored them as a "simplification" that ended up being quite deadly wrong; and
  • Because they are costs that are not immediately salient, so sometimes we just overlook them or we are not aware of them;
  • Most importantly, they are often spillover costs or externalities, which means that the people who incur the costs do not pay them, so they do not enter into their cost-benefit analysis.

"When we pollute, we reap all the immediate benefits, but the long-term costs are quite literally blown away to become someone else's problem. So there are costs to society as a whole, but the polluter is only affected by a tiny fraction of that.

"Hence, the choice that would be optimal for society is not the choice that is optimal for the individual decisionmaker. For example, we all choose to drive or fly, because we experience the benefits, but the carbon emissions that affect other countries or future generations don't enter into our calculations (unless we have altruistic preferences, which is another story).

"In other words, it's not that there are no environmental costs. Just that they are either not correctly estimated by individuals who incur them (we underestimate how much pollution we create or we underestimate the damage it does to us) or they are not borne directly or indirectly by these individuals (we know the costs happen but since we are not the ones coughing and we don't care about others, we just don't take them into account)."

Now that environmental costs are not so hidden as we can all see the change in climate, hopefully they will now be an integral part of every one of our economic equation going forward.

  • The writer is the portfolio manager of a no-management fee Asia fund, Inclusif Value Fund (www.inclusif.com.sg)