Investing Based on Opportunity Cost

Opportunity cost is crucial for decision-making. For value investors, understanding one's opportunity cost is vital; otherwise, what would be the basis for comparison when making investment decisions?

What is the opportunity cost?

Simply put, it's the cost of choosing option A over option B. If option A potentially yields a 100% return and option B only 5%, then the 5% can be considered the potential opportunity cost. Based on this principle, it's easy to conclude that the true cost of buying a stock isn't the purchase price but the opportunity cost of that capital (which can also include the investor's time and effort).

Do we have a number for opportunity costs?

Theoretically, in financial terms, it should be the short-term risk-free rate of return (i.e., compared to not making a decision, holding cash equivalents). However, the investment horizon varies for each person; even for risk-free returns (like U.S. Treasuries). As a young investor myself, statistically, I have nearly 50 years of investment horizon, and of course I hope for even longer, so for me (in U.S. stocks), using the long-term average return rate of the U.S. market, around 6-7%, is reasonable for my opportunity cost. If someone has an investment horizon less than 20 years, the volatility of stocks might impact them too much, making treasury yields (about 2-6%) more appropriate. This opportunity cost assumes you are holding cash; generally, this should apply to most people.

Regarding specific investment decisions, regarding how to buy, Warren Buffett (2004 Berkshire Hathaway shareholder meeting) believed that "What you ought to do is have your default position… is always short-term instruments. And whenever you see anything intelligent to do, you should do it. And you shouldn’t be trying to match up with some goal like that(asset allocation)."

This comment responded to someone asking about the viability of implementing a stock-to-bond ratio like 60/40 or 80/20 when building an investment portfolio. Buffett and Munger highlighted two points: 1) Making buy decisions (for long term capital growth) based on asset allocation is entirely wrong since allocation and investing are different matters. 2) Buy decisions should be compared against not buying (i.e., the short-term risk-free rate). If you're holding cash equivalents (short-term risk-free rate) and find something with a higher yield, then you can make that comparison.

In practice, we often find ourselves not always comparing with cash in the market; we might be holding another stock, property, or even currency. In those cases, the opportunity cost isn't just the short-term risk-free rate but transaction costs (fees, taxes, FX volatility) + potential returns. If you clearly understand your opportunity cost, say 10% over ten years, then when encountering other opportunities like buying an investment property for 20 years at 5%,or a stock likely to return 15% in ten years, or a friend's startup offering 50% in 3 years, you can better compare.

For U.S. stock investors, there are always two benchmarks for opportunity cost: the short-term (within 20 years) treasury yield at 2-6% depending on the market, and the long-term (over 20 years) U.S. stock market index annualized return above 7%. This is why many investment gurus recommend index funds; it's hard to find anything that can match the U.S. stock market's long-term stable high returns. If an investor's time horizon exceeds 20 years, they can achieve over 7% returns while lying on beaches doing absolutely nothing. This means that if an investor has a 50-year investment horizon, there's essentially an option in front of them that could potentially multiply their investment by 32 times in 50 years.

From this, we can infer that investing isn't just about using a telescope to find targets; rather, it's an inward journey. The key lies with the investor themselves—whether they can find and implement methods to outperform their opportunity cost over the long term.

Let's review the thoughts of the masters:

Buffett: “The real cost of any purchase isn’t the actual dollar cost. Rather, it’s the opportunity cost—the value of the investment you didn’t make, because you used your funds to buy something else.”

Munger: "If you have one opportunity that you already have available in large quantity, and you like it better than 98 percent of the other things you see, well, you can just screen out the other 98 percent because you already know something better."

Munger: “And on opportunity cost, going back to that. The current freshman economics text, which is sweeping the country, has written in practically the first page, and it says, ‘All intelligent people should think primarily in terms of opportunity cost. That’s obviously correct, but it’s very hard to teach business based on opportunity cost. It’s much easier to teach the Capital Assets Pricing Model, or you can just punch in numbers and out come numbers, and therefore people teach what is easy to teach instead of what is correct to teach. It reminds me of Einstein’s famous saying. He says, ‘Everything should be made as simple as possible, but no more simple.’

Munger: “We’re going to make different deals at different times based on different opportunity costs. There’s no other rational way to make deals.”

Munger on Buffett: Someone presented a company in an emerging market to Warren Buffett, Warren said, “I don’t feel more comfortable [buying this] than I feel about add-ing to our position in Wells Fargo.” He thinks highly of the company and the managers and the position they were in. He was using this as his opportunity cost. He was saying, “Don’t talk about anything unless it’s better than buy-ing more Wells Fargo.” It doesn’t matter to Warren where the opportunity is.

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Yongping Duan thoughts on opportunity cost are more expansive and nuanced:

DUAN: "Stocks are 'priced' by each buyer themselves; you should only buy when you 'personally' think it's cheap, which actually has nothing to do with the market (others). When you understand this sentence, your stock investment career has a very good chance of being profitable. If you don't understand, it doesn't matter because about 85% of people will never understand this, and that's fundamentally why these people will lose money in the market. Interestingly, I've found that most 'professionals' in the 'investment' industry don't really understand this either." (NetEase Blog, 2012-04-14)

Q: "Buffett says to buy good companies at fair prices. What does a fair price mean? What P/E ratio is fair? Or is there some vague standard?"

DUAN: "A fair price mainly refers to your own opportunity cost (which can be extended to societal opportunity cost). For example, if you like a company and think its return over the next 20 years will be 8% annually, but you're someone who can usually earn 10% annually, then you might want to wait and see if there's a better opportunity. If you're just putting money in a bank for 1% interest, then 8% annual return is good; don't listen to stories about your neighbor Little Horse making a lot of money, even if those stories are true. Here's an extreme example: you think a company can return 10% annually, but bank interest is 15%; what should you do? (In reality, the stock price would probably drop significantly.)" (2019-05-17)

Q: "I have a confusion to ask you: I like a company's business model (of course, at least I understand it), and the corporate culture is also good, but I can't determine what price is a good buy price. I know others can't decide for me, I need to figure out what price is good myself, but how do I go about understanding this? What are the specific methods and paths? For example, looking 10 years in the future, how do you know if the current price is good?"

DUAN: "Let me give an example: currently, Apple has a market cap of about $800 billion after subtracting net cash, with annual profits around $50 billion. If you think Apple's profits will only increase over the next 20 years and you can't find another way to earn more than 6% annually, then you can buy Apple. However, if you think Apple will go bankrupt without Jobs, or you simply think Apple is on a downward trend, you shouldn't buy. If you have plenty of opportunities to earn over 10% annually, you should invest there instead; investing in Apple wouldn't be the right decision. This is why investment decisions are based on opportunity cost." (2019-04-07)

Q: "How do you define 'cheap enough'? I'm confused."

DUAN: "Cheap enough is defined by you. For example, if you give me $100 and I guarantee to return $102 in a year, would you think it's worth it? You'd probably consider several options, mainly depending on whether you have other equally safe places with higher returns." (2010-03-26)

Q: "Please advise on an asset allocation or stock swapping question. If you hold two stocks, both valued at $1, one at $0.4 and the other at $0.9, should you swap? Isn't it that once your assets reach a certain level, you shouldn't bother with these small gains, as it might just confuse your thinking and not be worth it?"

DUAN: "If you're sure it's $0.4 versus $0.9, why wouldn't you swap? In reality, not swapping is often because you're not certain." (2010-04-27)

Q: "Is 'holding' equal to 'buying'? Is 'holding' equal to 'buying'?"

DUAN: "There's no standard answer, but I think distinguishing between 'buy to keep' and 'buy to sell' is very good. In fact, 'holding' at any moment is indeed equal to 'buying'; that's what opportunity cost means! However, if an investor really thinks this way, they might easily fall into the trap of constantly wondering 'is it overvalued?' 'is it overvalued?' 'is it overvalued?', then focus too much on the market rather than the business itself. The essence of investing lies in the business itself; the more you focus on the market, the more speculative your approach becomes. So-called 'value investors' should be able to decide whether to buy or sell a company completely independent of whether it's currently or will be publicly traded." (2014-08-30)

Q: "I've seen Buffett buy Coke over seven to eight years, buying during stock market downturns after the initial purchase."

DUAN: "Large funds buying into a company can sometimes take a long time, sometimes due to trading volume, sometimes due to opportunity cost — when new funds come in, you compare all targets, even when no new cash is added, you can compare the difference between companies you already hold. If you see a significant difference between two companies (looking with a 10-year or longer perspective), why not switch to the more suitable company? It took me a long time to buy NetEase, and for a long time, I couldn't find a better company for me than NetEase. Apple in recent years is the same. I remember once someone asked me about the maximum position I'd take in one company, I said I could accept up to 50%, but currently, I like two companies called Apple. Maotai in A-shares is similar." (2014-07-27)

DUAN: "At least within the companies I understand, there's no company that would make me want to trade Apple for it. From the perspective of holding equals buying, I'm essentially buying Apple every day." (2015-04-29)

DUAN: "When someone 'invests' always thinking about the market, they're bound to run into problems." (2015-11-24)

Q: "If you've invested in two companies, under what circumstances should you rebalance your portfolio?"

DUAN: "This is a matter of opportunity cost, which only you can answer. Of course, rebalancing for the sake of rebalancing is likely to be wrong." (2018-10-09)

Q: "Aside from the extremely successful contrarian investment in NetEase, why have you been more 'conservative' with investments in Maotai and Apple? Is it because opportunities like NetEase are once in a lifetime?"

DUAN: "I never thought my investment in NetEase was contrarian, nor did I invest in Apple or Maotai for stability. My investment standard is very simple: to find and hold companies with high long-term returns within my circle of competence." (2019-03-16)

Q: "Value is the standard for holding, and undervaluation is the standard for buying. So, at what level of undervaluation should one buy?"

DUAN: "Think about it 10 years from now, relative to your own opportunity cost." (2020-11)

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Understanding your opportunity cost helps avoid the psychological burden of sunk costs. Here, let's slightly diverge into the concept of sunk costs, because sometimes, sunk costs are part of considering opportunity cost. That is, when making investment decisions, we don't always compare with cash equivalents but rather with other assets. Thus, a common scenario is that the asset we are holding might not have met our expectations, like sitting on a train with an unknown destination.

DUAN: "A small story (the parking meter): Once, a friend was flying to San Francisco, and I went to the airport to pick him up. Since I arrived early, I put an hour's worth of money into the parking meter. As it turned out, he arrived early too, so when we got back to the car, there was still more than half an hour left on the meter. We decided to stay in the car for another half hour to not waste the money we'd already put in. In reality, perhaps no one would actually wait in the parking lot, but according to a survey, 85% of Fortune 500 CEOs admitted to having done something similar. I'm one of those 85%." (2010-03-30)

Q: "What does this story illustrate? That money must be spent wisely?"

DUAN: "This story illustrates that the money in the meter is already gone; it's foolish to waste more time on it." (2010-03-30)

DUAN: "This story is about sunk costs (also called sunk or stranded costs). Sunk cost refers to costs that have occurred due to past decisions and cannot be altered by any current or future decisions. The story shows wasting new investment to save already sunk money, resulting in wasted effort. Think about whether you've done something similar." (2010-03-30)

Duan Yongping: "Thinking about sunk costs reminds me of what Buffett said, 'If it's a hole, stop digging.' Look at how many people are digging their own holes." (2012-06-26)

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Going back to the earlier question, when we find ourselves on a train, and suddenly realize we have no idea where it's headed, what should we do?

1. Get off at the next stop (cut losses, figure out the situation first)

2. Keep sitting it out (continue digging your own hole)

3. See what other passengers do (watch the market)

Upon reading this, readers should realize that opportunity cost also depends on one's circle of competence. For the same company like Apple, Buffett thought the opportunity cost was favorable in 2016 (when Apple's P/E was around 14), using cash to buy and hold until 2024 (when Apple's P/E was around 33) before selling in large quantities. Duan, on the other hand, started holding a near-full position in 2011 (when Apple's P/E was around 12) until today. Comparing who is better here is meaningless because Duan describes himself as an "amateur" investor whose investment horizon, purpose, background, knowledge, and experience differ from professional investors like those at Berkshire Hathaway. Duan also mentioned telling Buffett privately that he believed Apple had a stronger economic moat than Coca-Cola, which apparently differs from Buffett's view. Whether he was right or wrong isn't important; the market is ever-changing, and there are no "what ifs" in investing.