“There is no such thing as a free lunch” – Popular saying
Opportunity cost is a basic economic concept that reflects the close relationship between scarcity and choice. The term was used for the first time at the end of the 19th century, in 1894, by David L. Green in his article “Pain Cost and Opportunity Cost”, although the concept was already used then and has been developed extensively later, both by economists as well as experts in other areas, such as psychology.
When we talk about scarcity, we generally mean that resources are limited: income, time, energy, among others. This means that nobody can do everything they want or be in two places at the same time. You must choose, and that means giving up something. At this point, opportunity cost comes into play, that is, the value of the best alternative that you are giving up. And in this respect, I hope that the four minutes spent reading this article, giving up any other activity, are worth it.
“Intelligent people make decisions based on opportunity costs” – Charlie Munger
Used primarily in the economic context, opportunity cost applies to any decision we make in our lives.
Any rational person takes, or should take, into account all the benefits and costs of each of the alternatives from which they have to choose, with the sole objective of maximising the difference between those benefits and costs. In other words, every rational being will try to minimise their opportunity cost and optimise the return based on the resources available to them, regardless of their nature.
The applications, as we have mentioned before, are numerous:
· When the Government decides to invest in, for example, building roundabouts, it should assess the alternatives to such investment: health, education, etc.
· When a doctor opts for a treatment, he or she will need to weigh up the value of other medical applications before discarding them.
· When we decide to enjoy our favourite hobby, we must consider the cost in time, money, personal satisfaction, etc. of other alternatives.
“I’ve listened to many cost of capital discussions and they’ve never made much sense” – Warren Buffett
In the investment world, the application of opportunity cost is clear and necessary to correctly choose between two or more investment alternatives. In order to decide, we need to be able to compare them and the usual practice is to compare the future benefits of both investments and exclude them at a discount rate.
As Francisco García Paramés clearly states in his book “Investing for the Long Term”, the discount rate applied by the financial community tries to collect a risk-free rate plus a risk premium. The first will, normally, be the bond issued by the government of the country of the investment that we want to analyse, while the risk premium is an additional return that is required from an asset for investing in it.
And like Francisco García Paramés, I believe that this definition is meaningless and has at least two conceptual errors: firstly, it assumes that investing in a government bond has less risk than our potential investment (does investing in Coca-Cola or the Spanish 5-year bond have more risk?) and, secondly, financial theory assumes that the risk premium is a market parameter and not for each investor, thus assuming that it can be applied equally to all investors.
All of the above is taught in all business schools through the Capital Asset Pricing Model (CAPM). I believe the theoretical and mathematical application of this model in real life is very limited: the formulas never consider all the variables and it is very difficult to collect all the interconnections between these variables in a single formula.
For this reason, at BC Winvest, like other large investors, the only criterion we use to evaluate our potential investments is our opportunity cost: the return on our portfolio. Consequently, when we analyse a new investment, we always demand a potential return higher than that of our portfolio at that time.
For an individual investor, without the legal concentration constraints that a fund can have, the ideal is to apply Buffett and Munger’s theory: the cost of capital is the return that we hope our best idea will produce. In this way, new ideas have to offer higher returns than our current investments. Otherwise, it would be logical to continue increasing our investments.
In the case of being a passive investor, the comparison could be made against an index that reflects the economy’s global performance, for example, the MSCI World.
“Everything should be made as simple as possible, but not simpler” – Albert Einstein
But if opportunity cost is such a logical, useful, and obvious concept, why isn’t it applied as much as it should? The answer is complex, but not impossible to explain.
The famous psychologist and Nobel Prize winner in Economics Daniel Kahneman describes it in his brilliant work “Thinking Fast and Slow”: most of the decisions and judgments we make are based on whatever information is available at the time, regardless of its quantity and quality (what you see is all there is: WYSIATI), and we do it naturally and quickly. In this respect, Kahneman insists that most decisions are
instantaneous and lacking in reason. This way of making decisions is easy, comfortable, intuitive and gives us a (false) sense of security.
Man does not have the innate ability to see beyond the nearest future and, on many occasions, we prefer the satisfaction of an immediate benefit (going on holiday, buying a high-end car, etc.) to a much higher potential benefit, although it may take a while to crystallise (having sufficient funds for a comfortable retirement). In the words of Bill Gates: “Most people overestimate what they can do in one year and underestimate what they can do in ten years.
Furthermore, of course, it is usually not as easy as choosing between option A and option B, but you have to strike a balance between a large number of factors that are sure to influence your decisions. We must add an additional derivative to this: the added difficulty of quantifying each alternative. Not everything is measurable and, therefore, the comparison between alternatives is not always perfect.
Also, in cases where it is measurable, we tend to underestimate costs. As with an iceberg, we are only able to see the surface, 20% of what we can see. We do not usually take into account the remaining 80%. For example, when a person decides to devote himself body and soul to his work, devoting many nights to his job and not spending quality time with his family, he is not only giving up watching Netflix with his wife or having dinner with his children, he may be giving up a better long-term relationship with them.
“Do I really want to spend $300,000 for this haircut?” – Warren Buffett
So how do we get opportunity cost into our decision-making mechanism?
First of all, be aware that we can do anything, but we cannot do everything. Every day we face thousands of decisions that carry an opportunity cost, no matter how small, which, if we do not manage correctly, can lead us to prioritise things that are not important and leave out others that are.
The second thing is to consider all possible alternatives, even doing nothing. Once you have the options in mind, you need to be able to answer three questions:
· How much do I value this (measured in time, money, effort, etc.)?
· What am I giving up today to have/do this now?
· What am I giving up in the future to have/do this now?
It seems like a complex process, but once it is internalised and automated, it becomes a basic tool to consider all the implications of our decisions and make them more rational and efficient