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Opportunity costs can weigh on your investment decisions. How stealthy are you?
Opportunity cost is an economic concept meaning that when you make a choice, you forego an alternative one. There is finite ability, money, and time. For example, you decide on a beach holiday, which means you couldn’t have gone to the mountains. Now sure, the mountains are still there, and you could go next time. But whatever happened at the beach – whether the sun shone, or the rain poured down – was a choice you made with the concomitant benefits or pitfalls.
With investing, the opportunity cost is even more acute as we really have finite money and we can’t buy everything. Sure, we could buy both Standard Bank and FirstRand and, if we wanted to, also Absa and Nedbank. But eventually we run out of cash and end up not deciding as we just buy all the banks.
As an investor I am always very aware of opportunity cost. The first point I would like to make, refers to when we hold horrid stocks. I have written before that it is a bad idea to hold on to that absolute dog of a stock hoping it recovers. It probably won’t recover. Worse, though, is that while you’re holding that horrible stock and hoping for better days, you’re not holding some other stock that is moving higher and generating a positive return.
For an investor, this is the crux of opportunity cost. Are you in the right stocks?
The right stock initially embodies all the usual important points. A sector that has great growth prospects built into the industry with a defendable moat that hinders potential competition. An example I often use, is food retailers targeting low-income consumers. All of us must eat, and urbanisation means there are more people in the cities and hence more foot traffic. When bad times hit, people who usually shop at higher-end retailers start to shop down.
Thus, a great sector with a moat such as food retail on a large scale, becomes incredibly hard to penetrate by starting a new chain of grocers now. It is almost impossible.
After having identified the sector, I now want the best stock in the space. I don’t want to own the second-best. I want the best one and then I want it at a great price. Overpaying for a stock hurts future profits and I am happy to wait for the opportunity for a great price to come along. Over the years I have learnt that the wait may be long, but the wait is always rewarded in due time.
But here enters another risk: the opportunity cost.
Sure, a strong dividend will help, but you’re left watching your stock going nowhere while others are running higher. This is your opportunity cost. With large-cap stocks this is usually less of a risk. Ultimately, a quality company will see its price move higher.
But in the small- and mid-cap space it is quite a different game. The JSE has several world-class small-cap stocks that have seen little or no price gains over recent years and in many cases prices have fallen. We can hunker down and claim the market is ignorant and one day will come to see what you see. But how long do you wait while the opportunity cost hurts?
In a booming market everything runs, but the last few years have taught us that a stock needs buyers. And lots of them. If the market is not agreeing with your assessment, you have to ask the hard question – you may be right, but will you make a profit?
