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For example, say I invest in a 5-year certificate of deposit at 3% annually. Let's assume the bank delivers on time (no defaults). However, a month after I buy it, another bank offered a 4% 5-year CD, and over the 5 years, the S&P 500 had a 5% annual return.

To narrow it down, let's also say inflation was 2% annually, so it was still positive after inflation.

Is there a term for the risk of a scenario like this, that the asset will get a positive, but inferior return?

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    "Opportunity cost" would be the closest term though I would note that one could argue for more than a few millions of possible returns over a period of time depending on what choices one makes. – JB King Nov 23 '13 at 21:36
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I'd question whether a guaranteed savings instrument underperforming the stock market really is a risk, or not? Rather, you reap what you sow.

There's a trade-off, and one makes a choice. If one chooses to invest in a highly conservative, low-risk asset class, then one should expect lower returns from it. That doesn't necessarily mean the return will be lower — stock markets could tank and a CD could look brilliant in hindsight — but one should expect lower returns. This is what we learn from the risk-return spectrum and Modern Portfolio Theory.

You've mentioned and discounted inflation risk already, and that would've been one I'd mention with respect to guaranteed savings. Yet, one still accepts inflation risk in choosing the 3% CD, because inflation isn't known in advance. If inflation happened to be 2% after the fact, that just means the risk didn't materialize. But, inflation could have been, say, 4%.

Nevertheless, I'll try and describe the phenomenon of significantly underperforming a portfolio with more higher-risk assets. I'd suggest one of:

  • the risk of "being too conservative", or "being too safe",
  • the risk of "being unaware of financial theory" (MPT and the risk-return spectrum),
  • or, the risk of "not taking enough risk"?

Perhaps we can sum those up as: the risk of "investing illiteracy"?

Alternatively, if one were actually fully aware of the risk-reward spectrum and MPT and still chose an excessive amount of low-risk investments (such that one wouldn't be able to attain reasonable investing goals), then I'd probably file the risk under psychological risk, e.g. overly cautious / excessive risk aversion. Yet, the term "psychological risk", with respect to investing, encompasses other situations as well (e.g. chasing high returns.)

FWIW, the risk of underperformance also came to mind, but I think that's mostly used to describe the risk of choosing, say, an actively-managed fund (or individual stocks) over a passive benchmark index investment more likely to match market returns.

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    Nice. The "Risk-free Rate" is always going to seem low compared to what one might hope for. By definition, higher returns require higher risk. – JoeTaxpayer Nov 22 '13 at 15:53
  • This is a good overall explanation. However, my question wasn't specific to this particular low-risk asset. I just chose that as a simple example. The question applies anytime you make a commitment to an investment (even if that happens to be a subprime mortgage bond), then find a better one later. – Matthew Flaschen Nov 24 '13 at 2:44
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    If by "commitment" you mean locking in (as opposed to just a current choice) then I'd also suggest "illiquidity risk", i.e. can't get out of the poorer-performing investment to switch to the better one. – Chris W. Rea Nov 24 '13 at 4:18
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    Thanks, @ChrisW.Rea. I think that definitely covers a major aspect of it. In fact, opportunity risk may just be an extreme case of illiquidity risk (if the asset were fully liquid, you could switch to the better opportunity). – Matthew Flaschen Nov 25 '13 at 21:59
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In my opinion the risk is about the lost opportunity cost. You can find a lot of articles about it on the net.

In big shortcut opportunity cost takes place each time you have to choose between two or more options and the tradeoff effect have its price. It is defined as value of best alternative solution. Quite good definition from wikipedia is as follows:

In microeconomic theory, the opportunity cost of a choice is the value of the best alternative forgone, in a situation in which a choice needs to be made between several mutually exclusive alternatives given limited resources. Assuming the best choice is made, it is the "cost" incurred by not enjoying the benefit that would be had by taking the second best choice available

Note that opportunity cost is not the sum of the available alternatives when those alternatives are, in turn, mutually exclusive to each other – it is the value of the next best use.

As you probalby think, this situation often happens in financial world, where investors always seek best from their point of view way to invest capital.

  • "Opportunity cost" was the phrase I was about to answer. +1 for this! – guiniveretoo Nov 22 '13 at 19:13
  • Yes, it's definitely related to opportunity cost. A closely related question is, "What is the term for the risk that the opportunity cost will be higher than anticipated?" – Matthew Flaschen Nov 24 '13 at 2:45
2

Opportunity cost is the term you're looking for.

I.e. (quoting from link)

Definition of 'Opportunity Cost' 1. The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.

We're looking for long answers that provide some explanation and context. Don't just give a one-line answer; explain why your answer is right, ideally with citations. Answers that don't include explanations may be removed.

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    This actually seems to be the correct answer, though a link and a more detailed explanation would be appreciated. – Matthew Flaschen Nov 24 '13 at 2:42
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    @FrankRizzo - links go stale. Clearly that is a good citation, but our preferred M.O. here is to link, cite, quote and expand upon the quote. We are hoping to make the Internet a better place, so adding value to the Investopedia article is better than a link. Also, please edit your answer directly. – MrChrister Nov 24 '13 at 18:50
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    Actually, I think opportunity risk (the original answer here) is the more precise answer. It is the risk that you will have to give up a subsequent opportunity, since your money is already locked in. – Matthew Flaschen Nov 25 '13 at 21:55
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I'm sorry for adding another answer @MatthewFlaschen but it is too long for a comment.

It depends on the situation. Say you buy shares of the Apple Inc. and want to know what is the lost opportunity cost. You need to find out what other opportunities are. In other words what are the other possible types of investments you consider. For example in theory you could try to invest in any company from S&P 500, but is it really possible (I don’t mean investing directly in index) . Are you really capable of researching each company. So in your case you would consider only a few companies as alternative solutions. Also after different time period each choice may be your lost opportunity cost.

To measure the risk you have to:

  • decide which is the second best option (first after putting your money long in the Apple shares)
  • gather required data,
  • conduct some statistical tests with usage of some coefficients and estimators and make your decision.

In conclusion I want to say that my goal was to picture in general how the process looks. Also this is just an exemplary answer. All is about in what finance field you are interested. For example in one field you use Internal Rate of Return and in other Value at Risk. Opportunity cost is to vague to exactly tell how measure its risk of wrong anticipation. It connects in every finance field and in every field you have different ways do deal with it. If you specify your question more, maybe someone will provide a better answer.

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For bonds - yes. Let's say you spend $100 on a bond with a 4% interest rate. Tomorrow a new bond is offered with similar credit risk but pays 5%. No one would pay you $100 if you wanted to sell your bond. On the other hand, if new bonds are generally issued at 3%, someone might be willing to pay more than $100 to buy your bond.

The amount of difference depends on the bond's duration. The difference between what a person will pay for a 10 year 5% bond vs 4% 10 year bond is larger than the difference between a 1 year 5% bond and a 1 year 4% bond. There is more time to earn the high rate in the 10 year bonds than for the 1 year bond.

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