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Opportunity cost and investing

Nov 18, 2008

The concept of opportunity cost is something that we come across in our daily lives. We use the concept when it comes to making decisions involving a variety of options. For example, what are the different activities one could do on a Saturday evening? Either spend time at home with family or go out with friends or go out for dinner or to a movie.

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.

Let us suppose an investor has the option of investing in a risk-free instrument such as a fixed deposit and stock A. Based on his 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 explains this 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 explained very well is that every time an investor decides to invest in a stock, he should always look at the other opportunities available around. The investor should always compare the stock with its peers. Similarly, when the investor already holds a stock, one should not automatically purchase more of the stock going forward. 'Averaging', as the practice is commonly known, is not rational by itself. It is necessary to look and evaluate at the other opportunities presented at the same time. This is where the function of opportunity cost steps in.

It is important for an investor to judge the reason for the stock's downfall. He should also reevaluate how the stock compares with other alternatives after the fall. The concept of opportunity costs helps in avoiding the mistake of blindly averaging one's previous purchases.

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