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Know Your Opportunity Cost

One Key to Successful Investing

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For the average investor without any understanding of basic accounting, economics, or finance, the best option over time is most often to dollar cost average into a diversified group of common stocks or a low-cost index fund. By spreading purchases out over time, as well as reinvesting cash dividends, your money buys more shares during market crashes and fewer shares during market bubbles. The result is often a lower weighted average price (known as “WAP” on Wall Street.) By following this system, preferably through direct electronic withdrawals from your paycheck, checking, or savings account, you can take all emotion out of building a complete portfolio, ignoring the day-to-day, and even month-to-month fluctuations of asset prices thinking of your collective stocks just as you would a house; steadily growing in value until you need to sell it years and years in the future.

However, as we pointed out in 7 Keys to Successful Investing, those investors with more experience would be wise to take the advice of Berkshire Hathaway Vice Chairman and famed investor Charlie Munger who said that every investment you make should be compared to your personal risk-adjusted opportunity cost. In this context, opportunity cost is defined as the expected compound annual growth rate of return, or CAGR, on the next best available option to you as an individual. For each of us, this is different. If you had been in the immediately family of Sam Walton prior to the IPO of Wal-Mart when the company was raising capital by allowing individual store managers to acquire ownership in the stores they managed, you would have been more likely to know how profitable the business was, the potential for market growth, and the talent of those running the show. This opportunity was not available at the time to someone working as a chef in Manhattan. When selecting an investment such as whether or not to acquire more shares of an index fund or to buy a bigger house in anticipation of a substantial rise in the local real estate market, the chef would have arrived at a different answer whereas the manager of Wal-Mart as they might be comparing the attractiveness of, say, shares of Exxon-Mobile against the returns they estimate they could earn by opening their own restaurant.

Here are some quick ways to gauge your opportunity costs. Ask yourself the following questions:

What are my liquidity needs?

It makes no sense to invest in common stocks, private businesses, or real estate if you are going to require liquid assets in the short-term (one year or less) for items such as a balloon payment on a bank loan, taxes, or any number of countless other potential reasons. Always maintain a conservative balance sheet by keeping sufficient cash and cash equivalents on hand to meet your daily funding needs. In many cases, access to a home equity line of credit can serve the same purpose.

What is my circle of competence?

One of the cornerstones of investing is reducing risk. No matter how attractive an investment may appear, if you lack the understanding to value the cash flows and project profits into the future, buying the stock is just as risky as throwing your money into a spin of the roulette wheel - at least you are likely to understand how that game of chance works as compared to derivatives! So, repeat after us: Never, never, never invest outside of your circle of competence. If you pass on a hot IPO that subsequently goes up four-fold, don’t kick yourself; it cannot count as an opportunity cost if you did not understand the opportunity!

What are the opportunities that are available to me and how do they fit within my priorities?

Take out a notepad and make a list of the investments that are available to you – stocks, bonds, mutual funds, real estate, a new home, storage units, a restaurant franchise, etc. Now, make another list that details your priorities – paying off your debt, staying home with your children, going back to school, starting your own business, becoming a millionaire, etc. Next, identify which assets and investment types will help you reach your priorities. For example, opening a franchised Tim Horton’s or Dunkin Donuts would allow you to become your own boss and build wealth for retirement if done correctly whereas shares of an index fund will grow your wealth passively without the need for you to do any work on a daily basis.

Get more helpful tips and information about building a portfolio

We have some great resources on building your portfolio that can help you quickly and easily make sense of the financial markets. Check out the following resources:

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