Understanding Opportunity Cost
“If we are all in agreement on the decision - then I propose we postpone further discussion of this matter until our next meeting to give ourselves time to develop disagreement and perhaps gain some understanding of what the decision is all about.”
Sloan encouraged his colleagues to think about the tradeoffs of alternative decisions. Only by continually thinking through a decision by trying to identify alternatives can we be sure we understand our preferred idea. In economics, we are taught to consider economic decisions by thinking through the notion of opportunity cost. Opportunity cost is the next best option one chooses to forgo whenever they make a decision. Consider the following example:
Sarah has $50,000 saved. She’s entrepreneurial, interested in do-it-yourself projects, and is good at detecting trustworthy from untrustworthy people. Sarah wants to start a business and decides to acquire a property and become a landlord. Using Roofstock.com, she finds a property with the following characteristics.
She says to herself, “this investment sounds reasonable; I think I can achieve a 4% return plus inflation, which is well over the 2% I’m earning in my high-interest savings account.” Sarah considers a few other homes on Roofstock and determines this is the best one and buys it thinking its the best choice she’s found. Has she fully considered her opportunity cost?
Relative Opportunity Cost
Why buy a single-family home when you could buy a small slice of tens of thousands of single-family homes run by experienced landlords like American Homes 4 Rent or Invitation Homes? These real estate investment trusts operate as scale landlords with likely lower acquisition costs and lower operating costs. It might be that the expected return on the scale players is higher than what she could do herself, not to mention the added benefit of liquidity. It could also be that these firms are poorly managed and that Sarah’s entrepreneurial passion and handiness will overcome her relative lack of experience and enable her to earn comparatively higher returns. I’d encourage Sarah to at least think through the relative opportunity costs of a similar business model operating at a different scale.
Absolute Opportunity Cost
Thinking about opportunity cost in an absolute sense, driven by checklists, is yet another technique that could help Sarah. Sarah might want to try and become wealthy by employing an idea called 12% or pass. For every investment idea that comes across Sarah’s screen, if she cannot using reasonably conservative assumptions to achieve her absolute opportunity cost to take a risk, she instead holds cash. Under this approach, she needs to be disciplined and not swayed by others' success. At parties, her friends might gloat to her that they’ve earned 10% that year, 8% more than she was making because she didn’t find a deal. I’d encourage Sarah to consider an absolute opportunity cost higher than 2% because she is entrepreneurial and observant. She is reasonably likely to find future deals that have a much higher return. Knowing yourself well enough to estimate what sort of deals you are likely to see in the future can be done by taking the average performance of your past transactions. Then use that average as an absolute return hurdle. This process results in an absolute hurdle that becomes higher as you improve as an investor.
Only after creatively considering absolute and relative opportunity costs should we make a decision. The best way to do this is to talk to your friends who are also interested in investing. Before doing a deal, I love to workshop the idea with my friends and ask them about their perception of the most appropriate opportunity costs. The more surprising their answers, the more I learn.