In economics, “opportunity cost” is the value you give up by making a choice.
The real cost of a choice is not just the time and money you spend on it – it’s also the value of the alternative. Investors face opportunity cost in every investment decision they make.
An example of opportunity cost
Let’s say that on March 21, 2017, you bought US$100,000 worth of Quantum Corp (NYSE; ticker: QTM), the U.S. data storage company. Earnings were surging, the company’s growth outlook was strong and analysts (as they often do) pronounced the stock a buy.
You did some research and agreed… and bought US$10,000 worth at US$6.90 per share.
But things didn’t go well. It turned out that you should have ignored the talking heads. One year later, Quantum Corp traded at US$4 per share, a loss of 58 percent.
Another stock caught your eye that fateful day in March 2017. It was Hewlett Packard (NYSE; ticker: HPE), the U.S. I.T. company. You could have bought shares at US$12.70 a share. But at the the stock didn’t strike your fancy. What was more, an analyst at a big bank had just downgraded the shares. So you passed…
… unfortunately. Twelve months later, Hewlett Packard was at US$18.70 per share, for a gain of 44.7 percent (not including dividend payments of nearly 3 percent).
And meanwhile, your US$10,000 Quantum investment was now worth US$4,200. But had you invested in Hewlett Packard, the same US$10,000 would be worth nearly US $14,700.
Your unfortunate decision to buy Quantum shares resulted in a US$5,800 loss. Add that to the US$4,700 you did not receive by investing in Hewlett Packard, and you have an opportunity cost of US$8,700.
Of course, you had no way of predicting the two stocks would perform so differently. Of course, at any point could you could have sold your Quantum shares and bought shares of Hewlett Packard. That would have changed the entire opportunity cost dynamic.
How to avoid falling victim to opportunity cost
Cutting losses is one of the most difficult decisions an investor has to make.
As we’ve said previously, the sunk cost trap is a pitfall in which an investor judges an investment based on the time and money already “sunk” into it. It’s hard to admit failure, so you keep soldiering on, hoping things will get better – despite mounting evidence to the contrary.
A smarter approach is to look at each portfolio holding, and ask: “If I didn’t already own it, would I buy it today?” If the answer is “yes,” then holding a stock that’s lost value may be warranted. But if the answer is “no,” it makes sense to sell and move on.
It’s also important to establish rules before buying shares to avoid the pitfalls of emotional investing. So have a mental stop-loss before you enter a trade.
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Use a trailing stop-loss to minimise damage
The best kind of stop-loss order is a trailing stop-loss. This order “trails” a rising stock by always resting a pre-determined amount (either a percentage or an absolute figure) below the stock’s most recent high (that is, since you’ve owned it).
(One important point: Make sure you don’t put a standing market order in at your trailing stop level. You don’t want to tell your broker when you’re going to sell. Make sure that you make it a mental level – not one that you tell your broker. And then watch it.)
For example, let’s say before you buy a stock for US$10 and put a mental trailing stop loss at 20 percent. That means if the shares fall 20 percent below US$10 (i.e. to US$8), you’ll sell (I calculated that price by taking 10 * (1-0.2)). Of course, twenty percent is a lot… but if you’ve decided that that’s what you’re willing to lose, then establish the stop loss, and monitor.
Let’s say that shares rise to US$12 after you buy. Now, instead of having your stop at US$8, your stop will be 20 percent below the highest price the stock has reached since you owned it – which is US$12. So your stop will be US$9.60 (12*(1-0.2)).
Remember, even if the stock then falls to US$11, your stop will stay at US$9.60 because US$12 is the highest price the stock reached while you owned it. That means that the worst thing that can happen (as long as you monitor the share price) is that you lose 4 percent of your initial investment.
A trailing stop allows you to “let your winners run,” while keeping a stop-loss order at progressively higher levels as stock moves higher. A trailing stop-loss allows you to focus on other things, because your trade management is on “auto-pilot.” It takes the emotions out of investing.
As an investor, it may be painful to take a loss, but doing so may allow you to find a better opportunity and reduce your opportunity cost.
Publisher, Stansberry Churchouse Research