What is the real cost of ownership?

Fashionistas have long popularised the concept of ‘cost per wear’. In other words, it doesn’t matter how expensive an item is, as long as it is worn enough times to justify the cost. By contrast, something that was very cheap to buy, but spends its life at the bottom of a wardrobe or requires expensive dry cleaning may be a poor investment. There’s a similar concept with the acquisition of investment assets, but also major purchases such as homes and cars – the total cost of ownership.

When making a decision, an investor should consider not only the upfront outlay but the cost of holding that asset throughout the period that they do so. The idea of examining the total cost of ownership is to refine investors’ decision-making by considering all of the different kinds of costs that arise.

This is common practice for companies. When acquiring a new business, or a new tool – say, manufacturing equipment – they examine the cost of making the purchase, a capital expense, but also how much it costs to run, an operating expense. An asset may be cheap to buy because it has high running costs.

Consider buying a dilapidated chateau: the upfront price may be low, but the cost of getting the leaky roof fixed, replacing the peeling wallpaper and installing a modern heating system may add vast sums to that initial outlay. At the other end of the scale, printers are often inexpensive to purchase but the cost may rise considerably with the consumption of ink cartridges or toner, not to mention time spent on maintenance and network configuration.

For most financial assets, the cost of ownership is small, limited to platform fees or brokerage charges, plus perhaps ongoing management fees.

What does this mean for investment?

For most financial assets, the cost of ownership is small, limited to platform fees or brokerage charges, plus perhaps ongoing management fees. This involves a small annual deduction from the value of a portfolio of stock market or other assets, or from a fund’s assets. The holders of equity portfolios or income funds may receive regular dividends, or bondholders’ coupon payments, that offset these costs, but they are still there.

A more difficult issue to take into account is inflation. While it may be hard to predict and expensive to hedge, inflation can be an additional factor in the total cost of ownership, even though most investors were oblivious to it for most of the 2010s. If an asset loses 3% of its value each year through inflation not offset by dividend payments or capital growth, this may be regarded as a cost of ownership. This has been a particular problem in recent years for bonds, whose yields have been often less than the inflation rate.

However, for the most part the cost of ownership is low for conventional financial assets. Investors may run into more problems with alternative assets such as wine, art or precious metals. Wine must be stored properly to preserve its value, and it also needs to be insured. This represents an ongoing cost for the owner of the asset that should be factored into the calculations of their overall return – and such assets offer no dividend, interest or other income to offset it.

Art has similar costs. Auction or brokerage fees tend to be a lot larger than with the purchase and sale of securities, and need to be factored into buying and selling prices. Artworks should be kept in controlled conditions to preserve their state of conservation, and the insurance costs on top also tend to be substantial for works of significant value.

These costs exert a drag on investors’ returns. Gold prices are often inversely correlated with interest rates – since it doesn’t pay a dividend, the opportunity cost of holding it is higher in an environment where cash benefits from high interest rates. The cost of ownership may also influence how an asset is priced by the market.

Total cost of ownership considerations don’t just apply to investments, but to many aspects of your household finances, with car ownership the most obvious example.

Other areas of your finances

Total cost of ownership considerations don’t just apply to investments, but to many aspects of your household finances, with car ownership the most obvious example. Because people are willing to pay more for a new car than they are for one with even a few kilometres on the clock (unless it’s a vintage Ferrari), the moment a brand new car leaves the showroom, it loses at least 10% of its value, which will fall by as much as 20% after a year. This depreciation is as much a cost of ownership as petrol, insurance or road tax.

In addition, a car with inefficient fuel consumption will cost more to run. This might be an important consideration in deciding between a combustion-powered and an electric car, along with guesstimates about future fuel price trends. There’s also the potential cost of repairs, which for an old or classic car will probably be higher (and that classic Ferrari will cost a fortune to insure).

All of this means that an expensive but extremely reliable and fuel-efficient car might turn out to be cheaper than one with a low upfront cost. Specialist publications offer comparison of total cost of ownership for various vehicles to help buyers assess their relative merits.

Similar calculations often apply to homes, for slightly different reasons. An old house may have romantic appeal, but it may be more difficult to repair, materials may be more expensive and you may need specialist builders. By contrast, newly-built apartments can have high service charges and amenity costs, but they may be better insulated and cost less to heat; installations like plumbing may be more reliable.

In general, however, an investor should consider the purchase price, add in all the potential ownership costs and divide the total by the useful life of the asset.

Calculating the cost of ownership

The factors that go into cost of ownership calculations are different for each type of asset. In general, however, an investor should consider the purchase price, add in all the potential ownership costs and divide the total by the useful life of the asset. For a car, it might be purchase price, operating costs, depreciation, insurance and repairs, minus the potential sale cost, divided by the number of years you expect to own it.

Total cost of ownership is just one factor in decision-making, but it can make it easier to decide between two assets that ostensibly appear similar in value and cost. It can help investors to be sure they’re not buying an asset that looks superficially cheap, but comes with a nasty sting in the tail.

This article is a part of the folder Special feature: making the right financial decisions