In my previous article, I touched on the importance of each investor’s opportunity cost when it comes to the discount rate (link to the article is here).
One of the questions I received was how to go about calculating opportunity cost for different investments. This is a great question, and I have yet to come up with a great answer. But I’ll try to share the common approach and the one I use personally.
Let me start with the first common approach. While I am not a believer of the capital market theory, I do think the capital market line is useful in that it gives you a logical and theoretical guideline. Invesopedia defined the capital market line as “a line used in the capital asset pricing model to illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio.”
This is a good start. If we think about it, opportunity cost is the reward/risk you give up for the alternative investment. Every investment you make should at least be compared to the least risky asset class or money market fund. Then,Ă‚ depending on your risk tolerance level, investment objective and time horizon, you move up or down the capital market line to find the risk adjusted return for the asset class that best mimics your risk tolerance level, investment objective and time horizon.
Let’s say you have a low risk-tolerance level and long-term horizon, with the investment objective of capital preservation and modest appreciation. The best low cost passive investment you can choose is an ETF fund that tracks the return of the index. The expected return of the index you choose will therefore be your opportunity cost. Unless you can find an investment with higher return and similar or lower risk, you should stick with the index fund. The implication is that you should perform the task of estimating the expected total return of the index fund. Alternatively, there are many free services that provide you with their expected return of the index. For instance, GMO publishes their seven-year forecast for different asset classes. GuruFocus also has a feature that shows the expected return of the market based on different metrics.
Another common approach is to use a pre-defined hurdle rate such as 10%, 12% or 15%. Some have argued for the simplicity of this approach because it eliminates part of the complexity one may get if he or she focuses too much on the preciseness of the expected return projection. A hard 15% would serve as the imaginary opportunity cost and anything below 15% would be automatically eliminated. The peril with this approach is whether the chosen hurdle is realistic. One way to check the reality is to pull out the track record and compare what happened versus what you expected. Did you really get better than 15% annualized return on most of your investment, or is the 15% a mirage?
Personally, I use a total return approach to compare different investment, which I wrote about a few times in the past (link 1, link 2). The formula is simple: expected return = expected fundamental growth + expected valuation change + expected return of capital.
The beauty of this approach is the clarity you get when you line all the investments up with their total expected returns. Let’s say you are comparing the following investments for the next five years:
- A corporate bond yielding 10% that matures in 2020, selling at 80 cents on the dollar
- Berkshire Hathaway B share (BRK.B, Financial) at $129
Through some analysis, you decided that the Berkshire’s book value can grow 10% a year, and the fair value multiple for BRK.B is 1.5 times book value. You know Berkshire is unlikely to return any capital to shareholders in the next five years. The expected annual return for the investments are:
Corporate bond = 0% fundamental growth + 5% valuation change + 10% yield = 15%
BRK.B = 10% fundamental growth + 3% valuation change + 0% return of capital = 13%
There you have it. Based on expected total return, you would choose the corporate bond over Berkshire Hathaway today. But what the formula did not capture is how sure you are with regards to each estimate, and that is definitely an art.
You can add other investments on the list. Coca Cola (KO, Financial) at 10% and IBM (IBM, Financial) at 16%, etc. Then you can ask yourself "if I can get 13% from Berkshire with similar risk, why would I own Coca Cola if I’m expecting 10%?"
The other beauty of this approach is that as market price changes, you can react to it in a more logical way. For instance, if Coca Cola’s price drops 20%, it will be reflected in your expected return formula immediately, and your expected return may shoot up to 15% instead of 10%, which makes Coca Cola a better value than Berkshire.
The problem I frequently encounter is when I have another investment that has a much higher expected return, but much higher risk than Berkshire. For instance, a foreign company I’m looking at has an expected total return of 25% a year, but the uncertainty is much higher than Berkshire. I have to make the judgment of how much excess return I should demand for excess risk.
I also incorporate probabilities into my approach by probability-weighing fundamental growth based on the possible future paths. To use Berkshire as an illustration, I might say there’s a one out of three chance each that Berkshire can grow its book value at 8%, 10% and 12% for the next five years. This would give me a probability-weighted expected fundamental return of 10% a year. Most likely the company I analyze has lower predictability than Berkshire, so both the rate of growth and the probability of each growth rate requires a good amount of rigorous analysis coupled with some imagination. This is why investing is both art and science.
Some investors use the intrinsic value or margin of safety approach. For instance, one may have calculated the intrinsic value of a stock to be $50 and it’s currently selling at $40, which gives you a margin of safety of 20%. Another stock gives the same investor a margin of safety of 25%, so it looks like a better option. My problem with this approach is that it doesn’t capture how long it takes for the market price to catch up with the intrinsic value. The first stock may offer a smaller margin of safety, but it may only take one year to work out, whereas the second stock may take three years to work out. My other problem with this approach is that it also doesn’t capture the return components and the dynamic nature of the intrinsic value.
My approach certainly is not the best out there, but it has been useful to me. It takes knowledge and experience to improve one’s thinking and process on such an important topic. I hope this article is helpful in terms of answering the questions some readers have with regards to opportunity cost. As always, feedback and comments are warmly welcomed.
