“If you take the best text in economics by Mankiw, he says intelligent people make decisions based on opportunity costs—in other words, it’s your alternatives that matter. That’s how we make all of our decisions.” -Charlie Munger
Most people make investment decisions by comparing a potential investment to other investments that are available today. Few people seem to include investments that might be available in the future in their comparison.
This isn’t surprising. It’s difficult to know what investments will be available in the future. But it’s important to recognize that opportunity costs are not fixed in time. The opportunity cost of making a choice today is not just between the other choices available today. You must also include the potential choices that will be available in the future. After all, money that you invest at a 5% rate of return today cannot also be invested at a 10% rate of return tomorrow, at least not without first selling the earlier investment.
Investors that consider future investment opportunities will not invest in a low return investment today unless they believe it is unlikely they will find a higher return investment in the near future. This tends to limit how low investment returns go.
I don’t believe most people invest that way. Most people only seem to consider investments that are available today. Let’s think about the consequences of that behavior.
People who only consider investments that are available today will try to buy more of the better investments. This drives up the prices of the better investments and drives their returns down. The longer this goes on, the harder it becomes to find any better investments that haven’t already had their price driven up. Investors are left with a choice between investments with moderate returns and investments with low returns. If investors continue to make decisions based on what is currently available to them, they will favor the moderate return investments over the low return investments. You can see where this goes. People who only choose between currently available investments tend to keep driving prices up and returns lower.
There is another way of describing the two investing approaches described above: relative value and absolute value. Relative value investors will buy something expensive as long as the alternatives are even more expensive. Absolute value investors won’t. This is why investing based on absolute value should result in better investment returns than investing based on relative value: seeking absolute value prevents you from buying low return investments.
Making investments based on absolute value is more difficult. It’s tough to accurately estimate what opportunities will be available in the future. That’s why fewer people invest that way. It’s important to keep in mind that relative value investors drive the market most of the time. Relative value investors tend to drive prices up and returns down over time. When prices are high and returns are low, even relatively modest setbacks can be very disappointing, which triggers selling, lower prices, and higher returns. The key for absolute value investors is patience when returns are low.*
*Footnote: At the time of this post prices seem high and returns seem low so it’s easy to interpret this post as a recommendation not to invest in the current market. While I do believe there should be investments that offer higher returns in the future, I have no idea when that will be. That might be so far off in the future that you’ll miss a lot of gains by waiting. Returns might not actually be that low right now if the economy improves. Or prices might be bid up even higher and returns could go even lower.