On opportunity cost

The opportunity cost of anything, says John Quiggin in his new book, Economics in Two Lessons, is “what you must give up so that you can have it”. So, for example, the opportunity cost of going to the cinema tonight is not just the cost of the cinema ticket and of the trip there. It is also the net value to you of the next best thing you could be doing, such as going to the pub. There would be an opportunity cost of going to the cinema even if you could get in for free.

Opportunity cost, then, recognises that choosing one thing means denying ourselves something else. It is, in Robert Frost’s famous words, the road not taken. If you are 'pro-cake and pro-having it' you are denying an essential fact not just of economics but of the human condition*.

You might think this is a trivial idea.

Maybe. But it explains a lot of otherwise puzzling facts. For example, older and better-paid workers are no happier at work than the low-paid despite doing nicer jobs. This is because they face higher opportunity costs of working. Being stuck in an office isn’t so bad if it gets you out of a dingy flat, but it is nastier if it keeps you off your yacht or golf course – especially because as we get older we become more aware that time is running out and therefore more conscious of opportunity costs.

It also explains a paradox pointed out by the University of Michigan’s Betsey Stevenson and Justin Wolfers. They show that American women are less happy now than they were in the 1960s despite having more freedom and better career opportunities. The paradox is resolved by the fact that more options means more opportunity costs and more regret. As Katherine Guthrie college of William and Mary and Jan Sokolowsky Society for Financial Studies say in an insightful paper, more choice “evokes significant discontentment”.

It should therefore be no surprise that opportunity cost also matters for investors.

For one thing, it largely determines the price of gold. Because it does not pay interest, there is a clear opportunity cost of holding it – the income you forego by not holding cash or bonds instead. As interest rates fall, this opportunity cost falls and so gold becomes more attractive and its price rises. Conversely, when rates rise (or are expected to) the opportunity cost of gold rises and so its price falls. My chart shows that in recent years there has been a huge correlation between the gold price and real yields on US Treasury bonds. Gold rose from 2007 to 2012 as yields fell, then fell from 2012 as yields rose. It’s no accident therefore that it should have recently hit a six-year high as yields have fallen again.

This implies that gold is nice insurance against recessions, because bond yields tend to fall then. But it also warns us that gold is unlikely to rise much more unless bond yields fall, and it might well fall if they rise.

Opportunity cost also matters for all stockpickers simply because the alternative to any active strategy is a simple index tracker fund. And the opportunity cost compounds over time. An extra percentage point of annual fees on a £10,000 investment could easily cost you over £1,000 over 10 years. Before buying any actively managed funds, therefore, just ask: given the opportunity cost, is it worth it?

There’s also an opportunity cost to saving. It’s obvious that saving means foregoing some consumer spending. What’s not so obvious is that if we deny ourselves nights out and holidays, we end our lives with few happy memories. It’s easier than you think, therefore, to save too much.

There’s one place, though, where we don’t see opportunity costs where we should – in company accounts. Companies do not report what their profits would have been, had management made other reasonable choices such as undertaking investment projects they declined. This can cause us to overestimate managerial competence because we don’t see the results of choices that they might reasonably have made but did not.

This might help explain why investors have often paid too much for growth stocks. It’s easy to see that a new or small company has lots of growth options. What we can easily neglect, however, are that there are opportunity costs to exercising these options. Not only does expansion require capital expenditure but also the focus on expansion can distract managers from holding down costs and increasing efficiency. The University of Liverpool’s Charlie Cai and colleagues have shown that investors “tend to ignore the negative impact of growth on asset turnover”. Greater awareness of opportunity cost might therefore help us avoid buying overpriced growth stocks.

Opportunity cost, then, matters a lot. While we might be aware of this fact at the time we make choices, however, we are less good at acknowledging it with hindsight.

This is partly because we never see the road not taken. As the 19th century French economist Frederic Bastiat said, the essence of opportunity costs is that they are unseen.

It is also because we hate admitting to ourselves that we were wrong, and we have several psychological mechanisms that help us deny the possibility of error. We find it easy to invent justifications after the fact for what were marginal or bad decisions. One of these is the tendency to overvalue what we have simply by virtue of having it, and thus to undervalue what we didn’t buy. Psychologists call this the endowment effect. It is one reason why investors often hold on to poorly performing shares. Related to this is the Ikea effect: we value things more highly if we’ve had to work for them, so stocks you’ve bought after spending hours researching seem attractive.

In truth, it isn’t a wholly bad thing that we do this. We can’t go through life beating ourselves up with regret. Our psychological well-being requires that we be happyish with the choices we made. On the other hand, though, if we never acknowledge our errors we’ll never learn from them. In this sense, there’s a tension between our psychological health and good decision-making.

*The English expression 'you can’t have your cake and eat it' is a clumsy way of expressing opportunity cost. I prefer the old Italian saying, 'you can't have the barrel full and your wife drunk'.