Opportunity cost is one of the most essential yet overlooked concepts in investing and life. As Warren Buffett (Trades, Portfolio) famously stated, “The real cost of any purchase isn’t the actual dollar cost. Rather, it’s the opportunity cost—the value of the investment you didn’t make because you used your funds to buy something else.”
Understanding opportunity costs is critical but often challenging. Let’s examine the perspectives of three investing legends—Buffett, Charlie Munger (Trades, Portfolio), and Seth Klarman (Trades, Portfolio)—on this core principle.
Defining opportunity cost
Before diving in, let’s define opportunity cost. Put simply, it is the potential benefit that is lost or forgone when choosing one option over another. When investing, opportunity cost is the return you could have earned on an alternative investment. Failing to accurately calculate opportunity costs can lead to poor decisions and missed chances.
As Munger once said, “Opportunity cost is a huge filter in life. If you’ve got two suitors who are eager to have you, and one is way better than the other, you do not have to spend much time with the other. And that’s the way we filter out buying opportunities.”
Buffett on seizing opportunities
Few investors have utilized opportunity costs as effectively as Buffett. From a young age, he recognized the benefits of compound interest and reinvesting gains. This focus on maximizing returns over time has guided his long-term buy-and-hold strategy.
At a 2001 shareholder meeting, Buffett emphasized that Berkshire Hathaway’s (BRK.A, Financial) (BRK.B, Financial) biggest mistakes were errors of omission—missed opportunities. He pointed to cases where Berkshire almost invested but passed, only to watch the stock soar. “In terms of the shareholders, those are the ones in our history that have cost the most,” he said.
He constantly weighs opportunity costs when deploying Berkshire’s ample cash reserves. As Buffett told CNBC in 2011 amidst market turbulence, “Berkshire bought $10 billion in U.S. Treasuries last Monday. We bought $10 billion in Treasuries this Monday. And the only question for next Monday is whether we will buy $10 billion in 3-month or 6-month.” Even with ratings downgrades, Treasuries offered better short-term returns than cash.
Buffett focuses on the best risk-adjusted returns at any moment. He holds cash when better opportunities are scarce but deploys it swiftly when prospects arise. This nuanced approach allows Berkshire to capitalize when markets swoon. As Buffett wrote during the 2008 crisis, “I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (...) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.”
Munger on patience and concentration
As Buffett’s business partner, Munger echoes the importance of seizing rare opportunities. At a shareholder meeting, he shared wisdom from his grandfather, who became the wealthiest man in town after weathering enormous hardship as an Iowa pioneer. As Munger explained, his grandfather got rich by buying farms during periodic panics and leasing them to thrifty Germans.
According to Munger, his grandfather imparted that there are just a few opportunities in life. Munger took this lesson to heart, focusing his investing in areas he knew best and pouncing when chances appeared. Though Berkshire is vast today, Munger still keeps over 90% of his family’s net worth in three stocks.
Munger believes diversification is foolish if the goal is high returns. He thinks investors can make more informed decisions by developing expertise and waiting patiently for quality investments. “You’ll be a heck of a lot poorer if you follow conventional financial theory,” Munger once remarked.
Klarman on risk and cash reserves
One of the world’s preeminent value investors, Klarman has also written extensively about opportunity cost. In his seminal book "Margin of Safety," the guru defines opportunity cost for value investors as “the rate of return that is forfeited or given up when an investor chooses one investment over another.”
Klarman argues that investment risk arises from uncertainty in underlying cash flows and paying too high a price. Therefore, value investors focus on assets they understand while insisting on a margin of safety through conservative valuations. He believes opportunity costs must be carefully weighed when deciding how much cash to hold.
While some view cash as a drag on returns, Klarman sees holding it as an option that enables investors to seize chances when markets swoon. “For an investor, there are only two things you can do – hold cash or be fully invested,” Klarman wrote. “Holding some cash at all times is critical.” Without it, investors sacrifice opportunities arising when others panic.
Applying the lessons
While Buffett, Munger and Klarman have distilled complex concepts into simple maxims, most individuals still struggle to accurately assess opportunity costs in practice. How can smaller investors apply the lessons of these investing legends?
First, focus your investing on areas where you have an informational edge or analytical advantage. Seek out hard-to-value assets that are ignored or misunderstood by the mainstream.
Next, take more concentrated positions in your highest conviction ideas rather than diffusing exposure across too many stocks. This enables more significant gains if your thesis proves correct.
Maintain sufficient cash reserves to deploy when prospects arise, however gradually. Holding some cash provides flexibility to buy at cheaper valuations when markets correct.
Exercise patience, waiting for the “fat pitches” before swinging rather than feeling pressured to be always invested. Developing emotional discipline is key.
Pursue continuous learning about industries and businesses throughout your investing lifetime. The cumulative knowledge will refine your ability to judge opportunities.
Methodically calculate opportunity costs when deciding how to invest your capital or which ventures to pursue. Consider both monetary and non-monetary factors in your analysis.
Recognize that risks always exist in investing. Focus on avoiding permanent loss of capital rather than getting caught up in volatility.
Approach opportunities with humility, acknowledging the limits to your knowledge. Strive to make rational decisions based on facts.
Finally, start early to allow the power of compounding to work its magic. Be consistent. Reinvest gains to accelerate growth. Let time and discipline drive the snowball effect.
The common thread is making rational comparisons of the pros and cons of alternatives before acting. Patience, selectivity and persistence are integral if you hope to profit from analyzing opportunity costs like Buffett, Munger and Klarman. Refining this skill takes a lifetime, but doing so can transform your decision-making.
The immeasurable impacts of assessing opportunity costs
Opportunity costs affect everyone daily, though few accurately measure these unseen costs. Simply reading wisdom from investing legends is insufficient – their principles must be actively applied. When deciding, train yourself to pause, rationally compare alternatives and reflect on what might be forfeited. Stay humble, for there are always unknowns. Yet your decisions will steadily improve with discipline, rationality and conscious opportunity cost analyses.
Seize compelling opportunities boldly when they arise. But first, reflect carefully, weighing all options. Do so with wisdom from masters, and you will make better choices while avoiding missed chances. Success often hinges on properly assessing opportunity costs. Make it a priority and reap immense benefits.
