Foregone return

What Is Foregone Return?

Foregone return refers to the profit or gain that was not realized because an alternative investment or course of action was chosen over another. It represents the hypothetical earnings lost by not pursuing a different option. This concept is crucial in investment analysis and financial planning, as it helps individuals and organizations evaluate the true economic cost of their decisions. Unlike actual losses, a foregone return is a theoretical value, representing what could have been earned. Understanding foregone return is essential for comprehensive financial evaluation, encouraging a thorough review of all available choices.

History and Origin

The concept of foregone return is deeply rooted in the broader economic principle of opportunity cost. Economists have long recognized that scarcity necessitates choice, and every choice inherently involves sacrificing the benefits that could have been gained from the best unchosen alternative. The Concise Encyclopedia of Economics defines opportunity cost as the value of the next-highest-valued alternative use of a resource.⁸, ⁹ This fundamental idea underpins foregone return, extending it specifically to the context of financial gains. While not a distinct historical "invention" like a financial product, the systematic consideration of foregone returns gained prominence with the development of modern portfolio theory and increasingly sophisticated decision-making frameworks in finance, which seek to quantify the benefits of optimal choices.

Key Takeaways

Foregone return represents the potential gain or profit missed when one investment or action is chosen over another.
It is a hypothetical concept, not an actual realized loss, but a critical component of evaluating the true cost of a financial decision.
Understanding foregone return aids in better portfolio management and more informed capital allocation.
It highlights the importance of evaluating all viable alternatives before committing resources.
This concept is closely related to opportunity cost but specifically focuses on unrealized financial gains.

Interpreting the Foregone Return

Interpreting foregone return involves comparing the actual outcome of a chosen investment against the hypothetical outcome of the best alternative. A significant foregone return suggests that a different investment path might have yielded better results, prompting a review of the decision-making process. It is important to consider the risk-adjusted return of the foregone alternative, as higher potential returns often come with higher risk. For instance, an investor who held cash during a bull market effectively experienced a foregone return equal to the market's gains. This can represent the "cost of sitting on the sidelines" in investing. A Reuters article highlighted how the cost of remaining out of the market has become increasingly stark, underscoring the significant foregone returns for those who haven't participated in recent market rallies.

While foregone return provides valuable insight into the effectiveness of past choices, it is a retrospective calculation based on perfect foresight. In practice, investors make decisions based on expected return and available information at the time, not with the benefit of hindsight. Analyzing foregone return helps refine future investment strategies by revealing the potential impact of different time value of money considerations and market scenarios on potential outcomes.

Hypothetical Example

Consider an investor, Sarah, who had $10,000 to invest. She considered two options:

Option A: Invest in a certificate of deposit (CD) offering a guaranteed 2% annual return.
Option B: Invest in a diversified equity fund that historically tracked a major market index.

Sarah chose Option A, the CD, for its security. After one year, her $10,000 grew to $10,200, representing a $200 gain.

During that same year, the diversified equity fund (Option B) experienced a strong market rally and generated a 15% return. If Sarah had chosen Option B, her $10,000 would have grown to $11,500, yielding a $1,500 gain through capital gains and potential dividends.

In this scenario, the foregone return for Sarah's decision to invest in the CD is the difference between the return of Option B and Option A:

$1,500 (Potential Gain from Option B) - $200 (Actual Gain from Option A) = $1,300.

Sarah's foregone return is $1,300. This amount represents the additional profit she could have earned by choosing the equity fund instead of the CD.

Practical Applications

Foregone return is a concept with several practical applications across various financial domains:

Investment Decision-Making: Investors often analyze foregone returns when evaluating past investment performance and refining future strategies. For example, a mutual fund manager might assess the foregone return from not holding a particular sector that significantly outperformed, informing future asset allocation decisions. The SEC's Investor.gov offers guidance on asset allocation, which implicitly involves making choices between different asset classes, thereby foregoing the returns of unchosen alternatives.⁷
Capital Budgeting: Businesses use the concept to evaluate potential projects. When a company chooses to invest in Project X, it foregoes the profits that Project Y could have generated. This analysis helps prioritize projects that offer the most significant potential benefit.
Personal Finance: Individuals apply foregone return implicitly when making choices like paying down debt versus investing, or saving for a down payment versus investing in a retirement account. The cost of inaction, or not investing, can be substantial over time. A Federal Reserve Bank of San Francisco Economic Letter highlights the economic and social costs that can accumulate from inaction, a principle directly applicable to personal investment choices.⁶
Government Policy: Policymakers may consider foregone economic benefits when choosing to allocate public funds to one sector over another, recognizing the opportunity cost of their decisions.

Limitations and Criticisms

While a valuable analytical tool, foregone return has limitations. The primary criticism is that it relies on hindsight. Calculating foregone return requires knowing the outcome of the unchosen alternative, which is impossible at the time the original decision is made. This makes it a diagnostic tool, rather than a predictive one.

Another limitation is the difficulty in accurately identifying the "best" foregone alternative. In reality, there are often numerous potential choices, and selecting the true "next best" can be subjective and influenced by factors beyond simple financial metrics. For instance, an investment that appeared to offer higher returns might have also carried significantly higher, but unquantified, risks at the time of the decision. Furthermore, psychological biases, such as regret aversion, can make individuals overly sensitive to foregone returns, leading to suboptimal future decisions. The "cost of inaction" concept, as discussed by the Federal Reserve Bank of San Francisco, suggests that behavioral factors can make it difficult for individuals to act, thereby potentially leading to significant foregone returns that are only realized in retrospect.², ³, ⁴, ⁵

It's also challenging to account for all variables that might have influenced the foregone alternative's performance, such as unforeseen market events or changes in a company's fundamentals. Inflation and changes in market conditions can also distort the perceived value of foregone returns over longer periods. The comparison might also be flawed if the chosen investment and the foregone alternative had significantly different risk profiles, making a direct comparison of returns misleading without proper benchmark adjustments.

Foregone Return vs. Opportunity Cost

While often used interchangeably, "foregone return" is a specific application of the broader economic principle of opportunity cost.

Opportunity Cost: This is the value of the next-best alternative that must be foregone when a choice is made. It's a universal economic concept applicable to any decision involving scarce resources, whether financial or otherwise. For example, the opportunity cost of attending college might be the income you could have earned by working during those years. The Concise Encyclopedia of Economics notes that opportunity cost refers to what one gives up to get what one wants.¹
Foregone Return: This term specifically refers to the financial gain or profit that was not realized because a particular investment or financial action was not taken. It is always expressed in monetary terms, representing unrealized investment income.

In essence, foregone return is a subset of opportunity cost, specifically focusing on the lost potential earnings from an unchosen financial alternative. All foregone returns are a type of opportunity cost, but not all opportunity costs are foregone returns (e.g., the opportunity cost of time spent not working).

FAQs

Q: Is foregone return an actual loss?

A: No, foregone return is not an actual loss. It is a hypothetical calculation of the profit or gain that could have been earned if a different investment or action had been chosen. An actual loss means you invested money and got back less than you put in.

Q: Why is it important to consider foregone return?

A: Considering foregone return helps you evaluate the true economic cost of your financial decisions. It encourages a more thorough analysis of all available options and can highlight areas where alternative choices might have yielded better results, informing future decision-making.

Q: How does foregone return relate to compound interest?

A: Foregone return can be significantly impacted by the principle of compounding. If you choose an investment that yields a lower return, you are not only foregoing the immediate difference in returns, but also the potential for that larger return to compound over time, leading to a much larger foregone return in the long run.

Q: Can foregone return be negative?

A: The term "foregone return" typically refers to missing out on a positive gain. If the alternative investment would have resulted in a loss, then choosing the less losing or profitable option would actually represent a benefit relative to that specific alternative, not a foregone return in the usual sense. However, the value of the foregone opportunity (e.g., avoiding a large loss) could be considered.

Q: How can I minimize foregone return?

A: While it's impossible to eliminate foregone returns entirely due to market uncertainty and the nature of choice, you can minimize them by conducting thorough investment analysis, considering a wide range of investment options, and employing strategies like diversification and periodic portfolio review. Focusing on long-term goals rather than short-term market fluctuations can also help.