Mental Model: Opportunity Cost

by | Oct 20, 2020 | Episodes, Mental Model | 0 comments

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Basic Definition

 

  • This is probably the most important mental model that I have come across and apply in my life, and it permeates almost every thought, decision, and action that I have.
  • To put it simply, if you spend energy, time, money, or other resources doing one thing, those are energy, time, money or resources that you cannot use for something else.

 

Explanation of the Concept

  • Everything has a cost.  Before you take action, weigh the cost!
  • From a big picture life perspective, think about the person you want to become.  Who is that person in your mind, if you visualize it?
    •  Maybe you see your future self as a successful investor.  What kinds of skills do you need to learn in order to be that person?  You would need an understanding of risk, how money works, be knowledgeable about at least one asset class, etc.
    • Maybe you see your future self as someone who is incredibly fit and healthy.  You rarely, if ever, get sick.  You have a lot of physical energy.  You can play sports or take part in other physical activities that are meaningful to you.  What kind of skills do you need to be this person?  You would need to understand the basics about nutrition and fitness, and you would need consistency in applying those principles over time.  You might even hire a specific coach or trainer, if you wanted to improve in a specific area.
  • Now what would it actually take, for real, to become that person?  All of those skills that you would need…what would you have to give up?
    • Let’s look at personal finances for a moment.  What would you need to give up to become an investor and generate a high income (having a strong – or at least a reliable – income is in a way, a prerequisite for investment because you need money to actually invest).
    • The University of Chicago found in a study that of families who earned less than $9,000 in a year, 34% of them watched more than five hours of television per day.  In the same study 1.1% of households earning at least $150,000 per year watch that much TV.  Now, these are just a few data points, but you can see the correlations.  If you want to increase your income, saying no to Netflix for a few hours a week and putting that time and energy into building a business of becoming a more productive employee could have excellent results.
    • Opportunity cost comes into play with our health as well.  Every time we choose to drive as opposed to walking, if we’re within walking distance, is a trade off between time and physical effort.  Time is a precious resource, so most people tend to prefer convenience and speed.  But efficiency is not the same as effectiveness – imagine what would happen if you just walked 1,000 more steps per day by parking your car (if you own a car) a little bit further away from the entrance of whatever building you go to frequently.  That might not seem like much, but over time the calories you burn will add up.
    • This applies to education too.  If you are eighteen years old, have a baby on the way, and have no money, you probably won’t have a lot of immediate incentive to go through a formal degree program.  Nope, you’re going to get yourself to work to pay all of your bills for your family!  Maybe you decide to attend night school, or forgo formal training altogether in favor of working in an industry such as sales that rewards performance over academic credentials. 
    • It’s all a trade off.  Life is a series of trade-offs, making one decision after another.  I’ve heard it said once that “success” in life can be defined by making a series of 1,000 small, good decisions, one after the other.

    The Mental Model in an Investing Context

     

    • Let’s now turn our attention to investing.  How do we apply this mental model to selecting stock investments and managing our portfolio?
    • One of the biggest opportunity costs in investing is the one between being invested and sitting in cash.  What percentage of your portfolio do you have in cash right now?  What percentage is in stocks or other assets?  One the one hand, every dollar that you have in cash is a dollar not working as a piece of ownership in a company that could grow.  On the other hand, every dollar already invested in shares of a company can’t be used for other opportunities in the market that might come up.
      • This leads to two main philosophies on cash allocation.  The first is that an investor should remain fully or nearly fully invested at all times.  The theory is that money should always be in the market working.  If you miss just a few of the best days in the market in a given year, studies have shown that your rate of return suffers significantly (because the stock market is so erratic and jumps up and down frequently).
      • The other philosophy is that an investor should keep a decent amount of cash on hand, ready for opportunities.  This percentage ranges, but some investors such as Seth Klarman of the Baupost Group keeps up to 30% of his portfolio in cash at times, depending on market conditions.
    • Another opportunity cost is that between different stocks that we have the option of investing in at any given moment.  There are several thousand stocks that are publicly listed for us to choose from – it can be overwhelming to figure out which one to pick at any given time.  We can use some basic criteria to narrow this down (consistently profitable, grows profits at a certain minimum rate, etc.)
      • We can think of stock opportunities as existing across three different dimensions: quality, value, and growth.  These three are not mutually exclusive, but often a company/stock opportunity will excel at one or two of these but not be so great at one or two of the other dimensions.

    Conclusion

    • As investors, we’re always looking at tradeoffs!  And in our life, we’re doing the same thing.
    • The reality is that in principle, saying yes to something always meanings saying no to something else.  That something else may not be that big or important, but every dollar, every minute, and every ounce of energy that you have is, in effect, potential energy with real utility.  
    • That may sound constraining but the opposite it also true – saying no to something means you have the freedom to say yes to something else.

    Want to listen to another episode or check out another company?  Check out the full archive here.

    Alex Mason

    Hi, I'm Alex and I'm an individual investor and podcaster who's curious about the world, especially when it comes to long term investing in the stock market. I'm always looking for better ways to analyze businesses and add more mental models to my brain's tool belt.

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