May 7, 2012|
Your stock has crashed. Should you blindly buy more?
Opportunity cost is defined as the cost of an alternative that must be forgone in order to pursue a certain action. It's the benefits one could have received by taking the next best alternative action.
The concept of opportunity cost is something that we come across in our daily lives. We use the same when making various decisions. For example, what are the different activities one could do on a Saturday evening? Spend time at home with family, meet friends, watch a movie or grab a meal at a restaurant - are just some of the choices.
Now, let's discuss a more relevant example.
Suppose an investor has the option of investing in a risk-free instrument such as a fixed deposit and a relatively higher risk stock A. Based on assumptions, he expects stock A to generate a 15% return over one year, while the fixed deposit will guarantee a return of 8%. In this example, if the investor chooses stock A over the fixed deposit, the guaranteed 8% return is his opportunity cost.
Charlie Munger has explained this concept aptly - "Everything is a function of opportunity cost. The concept of a hurdle rate makes nothing but sense, but a lot of people using this make terrible errors. I don't think there's any substitute for thinking about a whole lot of investment options and thinking about the returns from each."
What Mr. Munger explains here very well is that every time an investor decides to invest in a stock, he should always consider other opportunities available to him. Comparing investing in a stock with its peers is essential.
Similarly, when one already holds a stock that has fallen substantially from the purchase price, one should refrain from blindly purchasing more units of the stock. 'Averaging', as the practice is commonly known, is not rational by itself. Gauging and evaluating other opportunities presented at the same time is of utmost importance. This is precisely where the function of opportunity cost steps in.
A good practice would be for investors to judge the reason for the stock's downfall. He should also re-evaluate how the stock (and its valuations) compares with other alternatives after the decline.
The concept of opportunity cost is of utmost importance as it helps in avoiding the mistake of blindly averaging one's previous purchases, a practice that is followed by many investors.
||Devanshu Sampat (Research Analyst) has a degree in commerce and nearly 5 years of experience in equity research. He draws inspiration from successful value investors across the globe and constantly endeavours to refine his own unique stock picking approach. While a firm advocate of the principles of value investing, he believes in adapting a versatile investing strategy in response to varying market conditions. Devanshu contributes to our Megatrend investing service The India Letter.
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