Do you consider Opportunity Cost while you invest in Stocks?

 5^th June 2021

Do you consider Opportunity Cost while you invest in Stocks?

Dear Fellow Travelers,

Namaste! Business Models are always difficult to understand - Cigarette companies kill their best customers and Condom companies restrict their future customers!! Still, both companies are profitable!!! The same way our post on ITC was super hit with readers yesterday. Thanks for being a regular reader.

What is Opportunity Cost?

The Opportunity Cost is referred to the probable returns from the use of resources that are considered as a second-best option. This is the reason why it is also known as Alternative Cost. When a person has to give up a little in order to buy something else is called Opportunity Cost.

In simple words – say you have Rs.1 lakh to invest. Now, if you consider investing in shares or keeping an FD in Bank. Bank FD is giving you 5.5% per annum and your assumed rate of return on stocks is say 15% per annum. If you invest in FD, your opportunity cost is 15% for not investing in stocks and if you invest in stocks your opportunity cost is 5.5% for not investing in FD. Got it.

How NORMAL EDUCATED person uses this concept?

I have been dealing with investors for the past 30 years. They don’t know the word – Opportunity cost but after a year – particularly when they have suffered a loss in stocks – they will compare mentally – it would have been better had they kept their money in Bank FD. I am sure many of the readers may also have this kind of thought process some or another time in their investment journey.

Many financial writers also give this kind of comparison for the past 10-15-20 years by comparing 2 or more options.

In personal life also – Husband and Wife when they fight – they tell each other – I would have been better off had I got married to Mr. X or Ms. Y instead of you. They also don’t use the word Opportunity Cost but intuitively they are aware of the concept.

So, opportunity cost is known to all of us.

How Buffett and Munger use this concept?

One idea that stands out amongst the many is their emphasis of using opportunity cost as a filter. As Munger observes in Poor Charlie's Almanack: "Intelligent people make decisions based on opportunity costs - in other words, it's your alternatives that matter".

When Opportunity Knocks

The central idea is that the real cost of any purchase you make isn’t the actual dollar/pound 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. To illustrate this, in the 1998 Shareholder Meeting, Buffett explained that, the first question he & Munger ask themselves when looking at a potential investment is:

"Would we rather own this business than buying more Coca-Cola or more Gillette?".

Buffett calls businesses like Coca-Cola and Gillette the Inevitables because, not only do they have superior economics and growth prospects far into the future, but also their prospects are highly certain - if you do your homework, you can develop rational convictions about their future. "No sensible observer, questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime".

Because you have the opportunity to purchase these kinds of investments, they argue that you can use this as a filter to automatically eliminate the other 98%. We should want companies that get as close to perfection as possible, or we should figure we'd be better off buying more Coke. Buffet notes that, if every management, before they bought a business, said - "is this better than buying in our own stock or even buying Coca-Cola stock?", there'd be a lot of less unsound deals done.

READ underlined.

What is the difference between NORMAL Person and Buffett while using Opportunity Cost?

The smartest of the smart or Buffett kind of investor uses Opportunity Cost – before investing in any options. After considering both or more options they chose the option and they go ahead with that with full convictions. Then they are okay with whatever happens in the future. He has the power to choose the best every time.

Most normally educated people uses the opportunity cost – post investing / post marriage or after doing anything. When you do this kind of cost comparison post the event – this will lead to a negative frame of mind about investing / marriage or any work, in case your chosen option has not worked well. In fact, a normal person thinks about the alternatives only after he suffers the losses or pains from his current choice.

This kind of thinking makes them more and more biased and prejudiced to their chosen option. I have seen many guys run away from the market after suffering heavy losses in terms of money. But their biggest opportunity loss is their permanently closed mind for stocks due to their thought process.

What Next?

Knowing various techniques for success is a very good habit. Knowing them from FREE Google information is also good. You must go on developing them. The problem comes when you don’t know the timings of using that technique in investing and in life. Google can give you any technique FREE of cost, but to learn how to use it and when to use it – you will need a Consultant / Coach / Mentor or Guru.

Make your choice.

Have a great weekend.

Follow me on Twitter @hiteshmparikh /  WhatsApp - +91-9869425399.

 

Live With Passion…Invest With Passion.

 

Hitesh Parikh.