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Brian Flores
Brian Flores
Articles (126)  | Author's Website |

Why Investors Must Always Consider Opportunity Costs

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

February 18, 2016 | About:

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 (NYSE:BRK.A) (NYSE:BRK.B). 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 (TradesPortfolio):

"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.

About the author:

Brian Flores
"I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up and boy does that help, particularly when you have a long run ahead of you." - Charlie Munger

Visit Brian Flores's Website


Rating: 5.0/5 (6 votes)

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Comments

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

A greatly underestimated topic as value investors. Thanks for a great post. - Tom

jtdaniel
Jtdaniel premium member - 4 years ago

Hi Brian,

I really enjoyed your article and certainly agree with your premise. Over time, I have learned the value of simplifying my investment approach.Considering opportunity cost is a great way to avoid catastrophic losses. Why not compare any health care idea to Abbott Labs or Walgreen? If I can really find something better, well I must be on to a winner.

I see that a Motley Fool service is recommending a sale of Ultra Petroleum after a four-year hold and a 98% loss. At many points in the last four years,an Ultra share holder could have stayed afloat simply by switching to plain old Exxon with its boring dividends.Of course, no one at Motley Fool recommended such a prudent action. Some things we have to figure out for ourselves. Best, dj

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Great comment DJ. Your thinking - and the example you provide - are essential to providing adequate returns. We have a system at Nintai where we model opportunity costs against a relatively risk free option, industry leadership (per your example) and a third option of simply doing nothing. Thanks again for a very astute comment. Best. - Tom

jtdaniel
Jtdaniel premium member - 4 years ago

Hi Tom, thank you so much. Nintai is a beacon of light in the investing community.

Enjoylife
Enjoylife - 4 years ago    Report SPAM
Hi Brian,



Good article. This concept I personally struggle with. The idea that we can figure out which investments will do the best in a group is tough. I'm sure Warren and Charlie can do it. Just as I am sure Lebron can score 25 points a game against professional defenses in the NBA. But Lebron doesn't tell us how easy it should be for all of us to do. Or that we will score that much if we just follow his process.

Joel Greenblatt (Trades, Portfolio) has done some studys that showed when his model picked stocks, it outperformed the S&P. When people picked stocks they thought were best within the model group, they actually underperformed the S&P picking from the same group!

The point is what Charlie describes is actually very hard to do. To be able to accurately figure out how much two equites will return in the future and pick the best one is almost impossible for most people.

I would argue the best most of us can do is figure out some characteristics that generally lead to excess return. Like low PE, EV/EBITDA or PB stocks with high ROIC and low debt etc. Once we find a group that fits these characteristics, then I believe it is best to diversify equally among them.

In fact I'd go so far to say that since the future is not only unknown but also unknowable, it is a real danger to be too concentrated.

Now the challenge for me and I believe for most people, is figuring out the right level of diversity.

Even Charlie when he had his own partnership held 6-8 stocks. And Warren frequently had 10-12 ideas. But today people like Ackman and Pabria seem to think 6 or 8 is enough and create some wild swings.

For an indivdiual investor I believe the best risk reward trade off is probably somewhere between 15 to 30 ideas. Under 15 you run into too much idiosycratic risk and over 30 you lose any benifit of further diversification. Actually if you run over 10 billion dollar I'd assume you could even go up to 50 stocks and not lose much edge.

So while there is no one right answer on diversification, I believe it is irresponsible for Charlie to suggest that most people should practice extreme concentration. Owning 4 stocks like he does for DJCO would lead to disaster for most people who are not Lebron James of the investing world.

Just my 2 cents.

Thanks again!

Adam Parris
Adam Parris - 4 years ago    Report SPAM

Great article Brian.

Brian Flores, CFA
Brian Flores, CFA - 4 years ago    Report SPAM

Thank you all for your kind comments, really appreciate them!

apennar
Apennar - 4 years ago    Report SPAM

we have to remember we are always talking about the future when we talk about investment. The future is uncertain; the best one can do is try to describe the possibilities and make decisions based on these descriptions. Of course who makes the best descriptions will get the best results. If you are not so knowledgeable, your descriptions will be broader distribution curves- what means you should have more diversification, whatever the hurdle rate you choose. And if we were to use this relating to marriage we should adopt the Koran and have at least four wives...

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