Opportunity Costs
The hidden costs that we often fail to account for.
What better activity would you be doing right now instead of reading this blog post?
The answer lies in the assessment of opportunity costs- The hidden costs that we fail to assess due to a lack of prioritization of our goals.
Opportunity costs result from both the things we should be doing and things we should not be doing. This cost is inherently borne by each one of us with every decision we make and many a time we are not aware that we are incurring this cost.
This post will primarily focus on personal insights from investing, observations from my professional life, and lessons drawn from various examples in history.
In the world of investing, one can tangibly assess these costs.
Over the years, I have learned to evaluate opportunity costs, a skill that improves with time.
Some common questions on opportunity costs that spring to my mind:
Which fund or stock do I invest in today and what am I missing out on with this decision based on my long-term goals?
What cost am I bearing on my body by not going to the gym or what cost is my body bearing by eating this pizza today as against the plate of grilled chicken for my stated health objectives?
This tweet by Paul Graham simplifies that concept.
https://twitter.com/paulg/status/1750536059190931608?t=xja4YmjJsdMXFsg90a4NqQ&s=19
Every decision we make in our lives inherently comes with some form of opportunity cost.
Opportunity costs in the investment process.
The most practical assessment of opportunity costs that I can tangibly observe in my life comes from my profession in the field of investing.
The portfolio manager has to assess opportunity costs constantly to make decisions while aligning the portfolios of clients.
Let's say the fund manager invests in a consumer stock today. While balancing the portfolio, he must understand the gains he might be foregoing by not investing in an infrastructure stock or investing a relatively smaller sum in the infrastructure stock. This evaluation is not easy and can only be assessed in hindsight.
For example:
The fund manager invested in the consumer stock and made 100% returns but had he invested in the infrastructure stock he could have made 150% returns. The 50% return that the fund manager missed out on is the opportunity cost his investor and he will have to bear.
However, let's say the underlying index (the collection of all the listed stocks in the market) yielded a 50% return in 5 years. In that case, investing in the consumer stock resulted in a gain of 50% over the index.
There will always be opportunity costs that the portfolio manager will have to bear throughout his investing journey. However, it is important to understand the objectives and processes of the fund and whether the fund has met or exceeded the expectations communicated to the investor to know whether this cost impacted the goal that was laid out by the fund for its investors.
In this example, the fund set out its objective- gave a handsome return to the investor, and comfortably beat the benchmark. Despite this, there will be investors who will tell the manager that he could have earned more by investing in some other stocks or sectors and this virtuous cycle will never end in the game of investing.
Hence, defining a goal and coming to terms with it is important to avoid regretting opportunity costs borne by both the portfolio manager and the investor.
I picked up a simple methodology to view opportunity costs from an example in Shane Parrish’s book Clear Thinking with the three-lens formula:
View opportunity costs through three lenses:
Compared with what?
And then what?
At the expense of that?
He uses these three questions to analyze the choice of a Tesla against a BMW.
It is the question of the difference between a 42,000 $ car as opposed to a 37,000 $ car. When we compare the two many a time the price becomes the only factor without evaluation of other invisible costs. We are only viewing this choice through the first lens.
When we view this choice through lenses 2 and 3 we obtain a different picture.
Through the second lens, we observe that we may need to charge the 42,000 $ car more, pay more for maintenance, and assess how many long drives we will go through.
Through the third lens, we see- what if I had invested that money? What if I had used the money to pay my loan? what if I needed that money on a rainy day if a financial disaster hit my family?
With high-value purchases, multiple costs need to be evaluated.
This way of thinking helps those of us who are building careers with our salaries in our lives early on.
I read an excellent case study on the assessment of opportunity costs in an investing book last year based on a large acquisition that took place in 2015.
I will name the companies, Company A and Company B, and explain more of the mental models of assessing opportunity costs that I learned through this case study, rather than diving into the numbers.
Company A was the market leader in its category and the largest listed company on that country’s stock market at the time. It announced the acquisition of Company B, a large company in the same industry as Company B for a mammoth cost, the cost was more than the entire value of Company A.
While the analysis suggests that this massive cost is what caused the downfall of Company A, the actual reasons that were not assessed were the larger opportunity costs that Company A incurred while buying Company B, which were:
Selling off their existing attractive businesses to fund the acquisition
Reduced focus on their existing business due to the acquisition
Missed opportunities for the company while focusing on the acquisition
Each of these overlooked opportunities which were missed out on while focusing on the acquisition of Company B, ultimately led to a disastrous acquisition while failing to assess the impact of opportunity costs.
I use this metric when setting my daily calorie-counting goals. For instance, if I'm going out for a weekend night with friends, involving drinks and some food, I assess how these evening calories might impact my weekly goal. I then plan my calories in and calories out for the week accordingly, allowing me to fully enjoy that evening.
I utilize a mobile app to track and gauge these numbers. It has become a simple 2-minute exercise for me due to practice over the years, for those wondering why I am spending so much time calculating calories. This process has worked in managing my weight very easily over the last decade, which has hovered between the 74-78 kg range.
If I am training for a marathon, I assess how much the long-running sessions can have an unknowing impact on my muscle mass and weightlifting capacity during the training and vice versa when I am training to build muscle. With this in mind, I structure a plan based on my objectives and make peace with opportunity costs.
Conclusion
Evaluating hidden costs in your life becomes easier when you are spending time working towards the goal that you are prioritizing.
When you are clear on what your priority is, evaluating options becomes easier.
Working in the field of investing has made it relatively easier for me to assess opportunity costs in my professional and personal life.
The assessment of opportunity costs on the professional front is critical but on the personal front it should not overwhelm you or deprive you of joy from moments in life, it just becomes a matter of what you want to prioritize.
l also documented a similar thought process in my blog post written in 2022- Quitters Are Winners. It is a long one :)
