Opportunity Costs

I think a lot of investors fail to consider opportunity costs. When a person invests in a stock or bond, the opportunity cost of that decision is the forgone chance to invest the same money in something else that might provide a better return.

When an investor keeps money in stocks that are fairly valued or overvalued, he increases his opportunity costs because he forgoes the opportunity to invest in undervalued companies with better appreciation potential. Conversely, when an investor only keeps money in undervalued stocks, he minimizes opportunity costs by maximizing chances for appreciation. The goal is to keep opportunity costs as low as possible.

Once you start thinking about investments this way, certain investing ideas stop making sense. If you think in terms of opportunity costs, it seems irrational to adopt any investing rule unconnected to whether the position is undervalued and safe per traditional Graham/Buffett value metrics like PE, price to cash flow, debt to equity, current ratio, and DCF analysis.

In my case, I had certain investing rules that probably raised opportunity costs and reduced returns. One of these was an arbitrary limit on the number of stocks in my portfolio. When I was making concentrated investments in just a handful of companies, a la Warren Buffett, I set an upper portfolio limit of eight stocks. I needed this limit for practical reasons -- I couldn't learn everything possible about more than a handful of companies. I've since shifted away from concentration and back to a well-diversified, cigar butt portfolio, a la Ben Graham and Walter Schloss, largely because of the emotional challenges of Buffett's concentrated approach. I'm now making investment decisions based primarily on quantitative metrics. I don't need to know too much about each company, and my buy/sell criteria are based mainly on financial ratios.  

Given the simpler, mechanical nature of the Graham/Schloss approach, an arbitrary upper limit on the number of stocks in my portfolio seems unnecessary and probably raises my opportunity costs. An upper limit makes it more difficult for me to invest in undervalued micro caps. I originally planned to equal weight a portfolio of 20 to 30 cigar butt positions. I like equal weighting because it forces you to be contrarian and buy more of a declining position when the value metrics are still attractive. In Deep Value by Tobias Carlisle, Carlisle notes that equal weighting can significantly enhance long term returns.

Incorporating the idea of reduced opportunity costs, I now try to approximate equal weights across positions while still investing smaller amounts in undervalued micro caps, even if that means exceeding a 30 stock portfolio. I'm trying to reduce opportunity costs by bending or discarding rules that keep me from investing in the most undervalued companies. Unnecessary or inflexible investing rules -- whether it pertains to valuation, financial stability, or diversification -- increase opportunity costs and reduce chances for investment appreciation.

I'm reminded of Walter Schloss, who often held up to 100 positions, many of them very small. Schloss clearly tried to avoid inflexible, irrational rules about which undervalued opportunities he could take advantage of.  

Investors often seem to ignore opportunity costs when deferring taxes. When you hold on to a fairly valued or overvalued stock for tax reasons, you reduce tax costs but increase opportunity costs. That's because you give up the enhanced returns you could get -- on average -- by selling the overvalued stock and putting the money in a stock that’s undervalued and has better appreciation potential. John Huber at Base Hit Investing wrote the best article I've seen on this subject, titled "Portfolio Turnover -- A Vastly Misunderstood Concept." In my opinion all stock investors should read this article.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.