Why Investors Must Always Consider Opportunity Costs

Warren Buffett and Charlie Munger discuss the appropriate way to think about costs

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Feb 18, 2016
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As investors, we are constantly thinking of allocating capital towards our best ideas. However, with limited capital to allocate, and several alternatives, the idea of opportunity costs arises. An opportunity cost is defined as the value of the second-best opportunity that we forgo when we make a choice. That is, in a world where alternatives are mutually exclusive, and we must choose A over B, or B over A, my opportunity cost would be the potential gain of B, if I choose A and vice versa. Luckily, Warren Buffett and Charlie Munger have touched upon this subject with more fluency and important insights.

Charlie Munger (Trades, Portfolio):

"I would argue that one filter that's useful in investing is the idea of opportunity costs. If you have one idea that's available in large quantity that's better that 98% of the other opportunities, then you can just screen out the other 98%. With this attitude you get a concentrated portfolio, which we don't mind. That practice of ours which is so simple is not widely copied, I don't know why. Even at great universities and intellectual institutions. It's an interesting question: If we're right, why are so many other places so wrong."
 

"I just wanted to do the best I could reasonably do with the talent, time and resources I had available. That’s what I was doing then and now. Everything is based on opportunity costs. Academia has done a terrible disservice: They teach in one sentence in first-year economics about opportunity costs, but that’s it. In life, if opportunity A is better than B, and you have only one opportunity, you do A. There’s no one-size-fits-all. If you’re really wise and fortunate, you get to be like Berkshire (

BRK.A, Financial) (BRK.B, Financial). We have high opportunity costs. We always have something we like and can buy more of, so that’s what we compare everything to. All of you are in the game of taking the lot you have right now and improving it based on your opportunity costs. Think of how life is simplified if you approach it this way."

"Berkshire Hathaway is constantly kicking off ideas in about two seconds flat. We know we’ve got opportunity X, which is better than the new opportunity. Why do we want to waste two seconds thinking about the new opportunity? Many of you come from places that don’t do that. You’ve got to have one horse, one rabbit, one something or rather, and that rabbit is going to be thinking about something which would be ruled out immediately by an opportunity cost available generally to the place – but, it’s a different department. You have to be diversified and so on and so on. It’s easy to drift into this idea that opportunities don’t matter, you’ve got so many different ways of doing things that are better. It isn’t better."
 

"The right way to make decisions in practical life is based on your opportunity cost. When you get married, you have to choose the best spouse you can find that will have you. The rest of life is the same damn way."

"I've never heard an intelligent cost of capital discussion. Warren's way of having every dollar retained having to produce at least a dollar of market value is the best way to describe our cost of capital. But that's not what people mean when they say it, especially in business schools. But it's simple; our way is right and their's is wrong."

 

Warren Buffett  (Trades, Portfolio):

"Charlie and I don't know our cost of capital. It's taught in business schools, but we're skeptical. We just look to do the most intelligent thing we can with the capital that we have. We measure everything against our alternatives. I've never seen a cost of capital calculation that made sense to me. Have you Charlie?"

Charlie Munger (Trades, Portfolio): "Never. If you take the best text in economics by Mankiw, he says intelligent people make decisions based on opportunity costs -- in other words, it's your alternatives that matter. That's how we make all of our decisions. The rest of the world has gone off on some kick -- there's even a cost of equity capital. A perfectly amazing mental malfunction."

 

For investors, these comments provide a roadmap when thinking about our alternatives. The main takeaways that I found among these remarks are the following.

1) Our cost of capital should be influenced by our opportunity costs: Instead of thinking about weighted average cost of capital, the most prudent thing to do is set our opportunity cost as the hurdle to discount cash flows. Obviously, this is not fixed and does not operate in a vaccum, it has to move in line with interest rates and other expectations. But it is critical to always have in mind the rate of return that we would achieve if we invest in our second-best option.

2) Thinking about opportunity costs reduces over-diversification: A good question is, if in this investment I can achieve something that I will not achieve with other options, why should I continue allocating capital to the rest of them? Wouldn't it make more sense to remain fully invested until a better, or at least equal return opportunity appears?

3) Opportunity costs can be applied in every aspect of our lives:

Charlie Munger (Trades, Portfolio) has the ability not only to speak in parables, but in real-life situations that open our eyes. Thinking about marriage, for example, we can also implement the idea of opportunity costs, in choosing the best possible partner after careful analysis. It may sound harsh, but it is an aspect of our life that cannot be taken lightly. This idea, when extrapolated, can reap great benefits.

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