Opportunity cost is one of those concepts that slinks away from you when you’re not looking. For that reason, I start with the definition.
Opportunity Cost – “the loss of potential gain from other alternatives when one alternative is chosen”
How can the opportunity cost be zero? When you select your best alternative you sacrifice nothing. When you select your second best alternative, you expend opportunity on the foregone opportunity of the best. You sacrifice gain from the alternative foregone. The value of the foregone alternative is the opportunity cost.
When investing, how do you minimize your opportunity cost? Select the best option. But what of the opportunities you are ignorant of? A choice must be made. Will you seek more alternatives or not? What is your cost of seeking alternatives? If the cost expended to identify alternatives is greater than the opportunity cost made available then perhaps you have found the local minimum. The goal is not to minimize opportunity cost. This leads to fear of missing out. Instead, the goal is to achieve the lowest combination of costs and the greatest assembly of value.
I believe the most significant opportunity cost is incurred at the beginning of the investment journey. We begin with near limitless potential and then make one mistake after the other. It reminds me of a corn field. The per acre yield potential of a corn crop begins dropping immediately after planting –or as the result of poor planting conditions. The potential of the seed while in the bag is tremendous. Once planted, the yield potential per acre can only go downward from that moment onward. The crop gets too little water, or too little nutrition. Things happen and potential is eroded until harvest. However, the goal is not yield maximization, but economic maximization. If you over apply nutrition to preempt loss you waste resources.
When investing, the potential is highest at the earliest moment. We don’t gain on our investments, we make poor choices. We make one mistake after another, eroding potential, and realizing our own eventuality.
So how do you minimize your opportunity cost and maximize your potential? Select more of your best ideas. Why not own 100% of your best idea? Perhaps you should.
For Little Engine Ventures, we strive to lower friction costs, which includes the on-going search for alternatives, as well as things like due diligence and legal costs. Thanks to a plethora of curiosity I count my cost of searching near zero. Still, we installed some simple procedures to tip our tangible search spending in our favor. For us, we divided the target number of investments per year by a percentage of the deals transacted within a geography. From that calculation we expanded the geography from our home base outward until we optimized the impact of our planned actions. From there, it was simply a matter of selecting from the best alternatives available. The dense and overlapping search and action radius compounds word-of-mouth more efficiently. Many of our businesses benefit from geographic density as well so it made sense to align our interests. It’s not terribly complex, but it works. It’s also subject to change.
We rank-sort alternatives by margin of safety. Margin of safety is the percentage difference between price and value. Top ideas get more attention. This works in our environment because there are near limitless set of alternatives. I revisit our universe of alternatives no less often than weekly, and sometimes more. I try to uncover ideas that are right under my nose, and work out from there. The process works well with few alternatives, too. As your universe grows the procedure becomes exponentially more valuable. You compound knowledge, assign value and sort more quickly. We are striving to stay capable of doing small deals because a very large volume of small alternatives allows us to choose the best ideas according to safety and the lowest possible opportunity cost.
Individual business owners face similar challenges. Should you compare every vendor every time your company makes a purchase? Or, should you get the best solution you can every time once it is known? What about new product development? Or, opening up new regions? Should you forgo some new line of business because the current is good enough? What process do you use?
Mikel and I discuss the explore-exploit algorithm. How many alternatives should you consider until making a decision? It depends in large part what the objective is. For most decisions time is a limit. You gather information and then you must use the information you have. I like to imagine the end state as potential maximization and work backwards to minimize regrets… and minimize mistakes.
Thus, I believe low opportunity cost investing necessitates a low cost search for alternatives. Instead of telling yourself you cannot, ask yourself, how I can I discover more efficiently? How can I reduce the number of poor choices I make?