Use Opportunity Cost to Drive Your Investing and Lifestyle Decisions
Early in my investment career, I was casting around for a framework for making investment decisions. Having read the Intelligent Investor by Benjamin Graham, Security Analysis by Graham and David Dodd, I was already familiar with the concept of value investing. Yet, I felt that I was missing some way to decide what to buy and how to allocate my capital among my ideas.
At some point, in the course of my usual research into the backwaters of investing, I came across a quote from Charlie Munger (Warren Buffet's partner) about the framework that Warren and Charlie use to make investment decisions at Berkshire Hathaway. Here's the quote:
We use opportunity cost to run the portfolio."
Eureka! In that one simple quote, lay a tremendously powerful framework for making investment decisions: opportunity cost!
So lets explore the concept of opportunity cost and how we can use it to make investment decisions.
What is opportunity cost?
Opportunity cost refers to the value forgone in order to make one particular investment instead of another.
Opportunity cost is all about the most basic of economic concepts: trade-offs. If you make a choice, you forgo the other options for now.
The option you didn't choose sometimes turn out to have been the wiser choice, which is why opportunity cost is best measured in hindsight
Let's cement the idea of opportunity cost by looking at what would have been given up if certain famous people had chosen to do something else.
Examples of opportunity cost for famous people
- What if Julia Child hadn't begun cooking at age 37?
- What if Sam Walton hadn't started Wal-Mart stores at 44 years old?
- What if Walt Disney had never started animating?
- What if Elton John had never composed songs?
- What if Thomas Edison had stopped working on the light bulb when he failed the first few thousand times?
- What if Michael Jordan stopped playing basketball when he was cut from his high school team?
- What if Steve Jobs had never returned to Apple to lead its resurgence, fundamentally reshaping the future of technology?
- What if Elon Musk hadn’t decided to change the future of mankind by starting Tesla and SpaceEx?
We are no different than these celebrities. Every day we make decisions about how we spend our time, our money, our brainpower, our energy, and for every decision we make, there is an opportunity that we didn't choose. And it's the choice not taken that represents opportunity cost.
Examples of non - financial opportunity costs you may find in your life
You may not be a celebrity, but are you aware of the opportunity costs in your own life? Here are some examples of these hidden costs you may experience.
- What if you hadn't gone to the party where you met your spouse?
- What if you had bought into that financing deal that turned out to be a scam?
- What if you had gone to Stanford and become best friends with two now-billionaire technology giants?
- What if you had learned a new skill that got you promoted at work instead of binge watching Game of Thrones?
- What if you had worked during college instead of taking out student loans?
- What if you had become a gym rat instead of a foodie?
- What if you choose one restaurant over another?
You could go mad trying to figure out all of the things you could have done, but you also need to be decisive.
Your life is a result of your past decisions.
Well, what about opportunity cost as it relates directly to money? Are you a Starbucks fan? Here is a personal finance type of opportunity cost.
Let's say you have a Starbucks coffee that costs you $4. Each time, in exchange for a beverage you could make at home for cents on the dollar, you spend $4. Each time you spend $4, you are giving up $470 in wealth fifty years from now. This year, if you buy 50 coffees for $200 this year, you are giving up $23,500 in future wealth 50 years from now. Ouch.
The point here is not to give up everything that you love, it's to hammer home the opportunity cost of the daily decisions we make.
Quality of life must play a factor in your analysis and more money does not always equal a better life. (Though all else being equal, more money is preferable because it increases the total options you have at your disposal.
Let's look at an example of two people who are similar but make one different choice that ends up creating a huge difference in their wealth.
- John is 18 years old. He gets an after school job and opens a Roth IRA. He saves $5,000 per year in it and continues doing this until he turns 70 years old. He is perfectly average, invests in low-cost index funds, dollar cost averages, reinvests his dividends, and earns the same return the market has for the past century or two - roughly 10% pre-tax and inflation. As a result, he ends up with a little more than $7,000,000 in wealth.
- Adam is also 18 years old. He gets an after school job but doesn't save anything. He waits until he is 30 years old, at which point, he opens a series of retirement accounts and saves $5,000 per year. He's only $60,000 in total contributions behind John, and still has 40 years to go before he turns 70, so he figures it isn't too bad. When he reaches retirement, though, he has only $2,200,000.
That $60,000 shortfall between John and Adam turned into a $4,800,000 canyon in net worth after 50 years. Ouch.
Let's get back to opportunity cost as it relates to investing.
How to Run Your Portfolio on Opportunity Cost
It's obvious that the implication here is that we need to have choices in order to use opportunity cost as a framework. Many investing mistakes are made when people fall in love with one business and fail to compare it to other ideas before making an investment decision.
How many choices do we need? There is no requirement for how many options you need to have to use opportunity cost, just as long as it's two or more.
Here are some ideas for the ways securities can be compared when using opportunity cost:
- The same company in different decades
- The same company performance over 3 years, 5 years, 10 years, 20 years
- Two companies of similar size in the same industry
- Two companies of different sizes in the same industry
- Three companies in three different industries of similar size
- Three companies in different industries of different sizes
- Two different companies in different industries with same valuation
- Compare the returns of stock investments to bond returns
- Compare returns same capital invested in real estate, stocks, and corporate bonds or US Treasuries
As you can see, you should always be able to find something else to compare an investment idea to. In fact, you should almost always compare return expectations from stocks to expectations from bonds.
OK, lets go through a few examples of this kind of comparison to bring the concept home.
For our first example, let's assume you have $15,000 that you could either invest in Company XYZ stock or put toward a graduate degree. You choose the stock. The opportunity cost in this situation is the increased lifetime earnings that may have resulted from getting the graduate degree -- that is, you choose to forgo the increase in earnings when you use the money to buy stock instead.
Here's a second example. Let's say you have $15,000 and your choice is to either buy shares of Company XYZ or leave the money in a CD that earns only 5% per year. If the Company XYZ stock returns 10%, you've benefited from your decision because the alternative would have been less profitable. However, if Company XYZ returns 2% when you could have had 5% from the CD, then your opportunity cost is (5% - 2% = 3%). In this example, the opportunity cost an be calculated with actual numbers.
Here's a third example. You have $15,000 to invest and you are trying to decide between a technology stock with no dividend, and a blue chip stock with a steadily increasing dividend. If you invest in the technology stock, your only return would be capital appreciation. You are speculating that the stock will rise. The blue chip stock will steadily lift its dividend and also has the potential of appreciation. Which one would you invest in?
No-one but you can ultimately decide which direction to go in, but you can help yourself out by giving yourself comparable choices to refine your decision framework.
How does liquidity impact opportunity cost analysis?
If two investments have the potential to generate the same return, but one requires you to tie up your cash for two years, while another won't allow you to touch your money for 10 years, you need to make a decision based on how liquid you need your money to be.
One option may be more attractive based on the predicted rate of return, but the other option may be more appealing based on the need for your money to be liquid.
The biggest opportunity cost when it comes to liquidity has to do with the chance that you might pass up a really attractive investment because you can't get your hands on your money that is tied up in another investment.
What if I do Nothing?
Unfortunately, doing nothing has infinite opportunity costs. You are choosing not to choose. Especially when it comes to building your net worth, doing nothing results in staggeringly large foregone wealth.
What is the key to using opportunity cost as a decision framework?
In a word, education is the key to using opportunity cost as a framework to make decisions. Education will give you more options. To all I would recommend intense study in any area of your life that you think opportunity cost is having the most impact, whether its money, investing, health, how you spend your free time, or relationships. You'll find that if you can master opportunity cost in one area, you will find it easier to apply to all areas.