Opportunity cost is generally defined as the cost of missing out on a particular opportunity when another option is taken.
According to Warren Buffett (Trades, Portfolio), the opportunity cost is the only thing he thinks about when evaluating whether or not one stock is worth buying compared to another.
However, it is difficult to assess the opportunity costs of different investments in times of crisis. This is the challenge investors face today.
Opportunity cost in times of crisis
The opportunity cost of taking one investment over another is difficult to determine because the outlook for so many companies is so uncertain. Trying to evaluate which is the best opportunity in the current economy and market is more challenging than it has been for some time.
Nevertheless, while it can be more challenging to assess opportunity cost in times of uncertainty, it can be "way more profitable," according to the Oracle of Omaha.
He made these comments at the 2009 Berkshire Hathaway BRK.A BRK.B annual meeting of shareholders when commenting on the investment environment at the time.
Buffett declared that while it was difficult to establish opportunity cost in times of uncertainty, his conglomerate always had "extra levels of safety," that prevented it from having to make rushed and difficult capital allocation decisions in times of crisis.
"We will never get so we are dependent on banks or other people's money or anything else," he said. "We are just not going to run the company that way," Buffett added.
Buffett then went on to describe the investment environment Berkshire faced in 2008/09. At the time, deals were piling up as companies queued up to ask the conglomerate for help. Buffett obliged, making $5 billion available for Goldman Sachs GS and $6.5 billion for the Wrigley-Mars deal, among others. This placed enormous strain on the group's balance sheet, and Buffett decided to sell some public equities to improve liquidity.
Most investors reading this will probably never have to deal with cash demands of this size, but the numbers don't really matter. What we can learn from this is the importance of being liquid in uncertain times and making tough decisions in a fast-moving environment.
Buffett explained that Berkshire had to consider things like transaction costs, whether or not a deal would close in time and whether or not it would hit regulatory scrutiny. All of these factors went into assessing whether or not the opportunity was worth chasing.
Other factors considered included the return rate on one deal compared to another and the certainty of returns. There was no one set answer to any of these questions. All Buffett and the team at Berkshire could do was try and work out whether or not each decision was right based on the potential rewards, risks, the group's liquidity profile, and predictability of returns.
Above all, liquidity mattered. As Buffett explained, he sold Johnson & Johnson JNJ in 2009 to be sure Berkshire had more than enough money to complete all of its deals:
"So it was the first time we really faced the question, you know, can we raise a couple billion dollars in a hurry, to be sure that we've offset the cash needs of what we're committing to on the purchase side. On the Johnson & Johnson we sold, we actually made a deal where we got — I had a floor price on what we sell that for, just because the markets were so chaotic, that we wanted to be absolutely sure that we would not end up a couple billion dollars less than comfortable when we got all through. Our definition of comfortable is really comfortable. We want to have billions and billions and billions around. And then we'll think about what we do with the surplus."
This is just as important for the average investor is it was for Buffett in 2009.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- An Alternate View on Why Berskhire Hathaway Is Buying Snowflake
- Why Warren Buffett Still Owns Struggling Businesses
- Berkshire Hathaway's Snowflake Deal Shows Us Where Warren Buffett Is Heading
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