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As an Investor, Do You Know Your Cost of Capital?

When retail investors jump into the stock market, they may not know exactly what to expect, especially when it comes to investment returns. Some may be happy just to eke out a small gain, while others may be frustrated that their get-rich-quick scheme didn't quite pan out as planned.

That's OK because all of these things teach you how to invest and help you develop your own personal style. But in the early stages of investing, it's helpful for retail investors to try to understand their own personal cost of capital. Let me explain.

What is the cost of capital?

Cost of capital can have a few different meanings in the finance world, but here, the cost of capital refers to the return that publicly traded companies need to generate in order to attract investors to their stock.

Let's break this down. Companies know that trading equities can be riskier than other investments. For instance, right now you can invest in a very safe 10-year Treasury note backed by the U.S. government and earn close to a 1.3% yield annually. Businesses try to figure out the annual return they need to generate in order to lure investors away from safer investments like the 10-year Treasury, and make them realize that an investment in them is worth the risk.

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But if a stock is struggling and maybe only appreciating at a measly 2% annually, why would a retail investor want to invest in that stock over a 10-year Treasury bill? Is the 0.7% extra in yield worth the headache when you could own the 10-year Treasury note at 1.3% and not worry as much? The answer is different for everybody. Maybe that 0.7% is worth it for a hedge fund investing tens or hundreds of millions of dollars, but to most retail investors, 0.7% is not likely to move the needle. Now, if that stock does better and earns 8% or 10%, that's much more enticing and may be worth the risk.

What's your cost of capital?

Cost of capital is usually a term used by companies because they are trying to figure out what their returns need to be to generate interest from the broader market.

However, it's useful for retail investors to flip this concept around and try to figure out their own personal cost of capital. What kind of returns do you need to achieve to make an investment worth the risk? Not knowing the type of returns you at least hope to achieve can make exiting an investment difficult.

When things are going well, it may seem like the stock will never stop rising. But then you wait too long, the stock falls, and you miss out on returns you would have been perfectly happy with because you let your greed and imagination get the best of you. Timing the market is nearly impossible.

Personally, I typically invest somewhere between a few hundred and a few thousand dollars in stocks I like. At this level, I'm trying to be a little more aggressive and find stocks that can double (again, this just me). Because let's say I invest $500 in a stock and that stock generates a 30% return in two years. I think most people would agree that the company's performance is pretty good with this kind of return.

But for me, the return doesn't do a whole lot. A 30% return on my $500 investment is $150, and then I likely have to pay the 20% long-term capital gains tax when I sell, reducing my after-tax return to about $120. For me, that is not worth the risk of investing in one individual stock. But another important thing to understand is that I'm being a little more aggressive with a few hundred or a few thousand dollars because financially I would be OK losing it (not that I wouldn't be upset).

However, if I look at something like my retirement portfolio, I am more than happy to invest the funds in a safe mutual fund that only generates a 5% or 8% return per year. This is because these funds will be critical for me down the road, will not be accessed for decades, and are a much larger amount than I would invest in a single stock.

Approach every investment differently

Everyone should have their own cost of capital based on their own specific financial situation and based on each individual investment they make. If you're investing just a few hundred dollars out of a much larger portfolio, you might be more aggressive because it's not that much money to start with and you can afford to lose it. Your cost of capital in this situation is higher. But when it comes to a retirement fund, invest more conservatively and be happy to go slow and steady. In this situation, your cost of capital is lower.

Ultimately, try to figure out your cost of capital going into every investment and once you hit your return, really try to evaluate where your investment stands. If the company you invested in seems to only have just started on a new period of growth and profitability, maybe it makes sense to leave your money in. However, if the company has a very high valuation or is facing some headwinds in the future, maybe it makes sense to take your gains, or at the very least begin curbing your investment.

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