Alternatives and Opportunity Cost

ALTERNATIVES

If you've got two suitors who are really eager to have you and one is way the hell 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.

• Charles Munger

"Allocate the money to us!"

How should we best allocate our scarce resources? TransCorp has ten different projects to choose from. Should they invest in all? Should each project get the same amount of funding? People, money, time, talent and other resources are limited. They also have alternative uses. Some options are also better than others.

Opportunity cost

"I weigh my use of capital and time against other available alternate uses."

One filter that can be used to measure choices against each other is our own personal opportunity cost. Our time and money are limited. If we make a decision to do one thing we are deciding not to do some other available thing. Every minute we choose to spend on one thing is a minute unavailable to spend on other things. Every dollar we invest is a dollar unavailable for other available investments. If we decide to spend money today instead of investing for the future we give up the opportunity to spend more in the future. If I decide to play golf today I miss the opportunity to finish this book on time. If I write, I miss the opportunity to spend time with my children. Since children grow up, this opportunity has a time limit.

Choices have costs. Even understanding has an opportunity cost. If we understand one thing well we may understand other things better. The cost of using a limited resource like time, effort and money for a specific purpose, can be measured as the value or opportunity lost by not using it in its best available alternative use.

Do you choose to work or go to college?

What is the real cost of choosing one alternative in favor of another? To use a somewhat changed example from Warren Buffett: What is the real cost of not having a college education? What is the difference in income over a lifetime between having an education or not? If we set aside non-economic benefits, discounted lifetime earnings provide a starting point for the comparison. A fuller calculation also includes tuition, earnings forgone while studying, and uncertainty about later income.

What is our time worth?

Do we spend ten hours doing repairs on our house or do we use a carpenter? The opportunity cost of doing the repairs ourselves is the value of the best alternative use of that time, whether paid work, rest, or something else we care about.

Does "free health care" mean it is really free?

No, had it not been free, the resources used for providing free health care could have been used for something else. Often we only see the benefits of government spending. We don't see what is prevented from happening or that resources are diverted from alternative uses.

"Employ 3 more sales representatives in Montana."

Should TransCorp take the time, money and talent to build a market presence in Montana? The real cost of doing that is the value of the time, money and talent used in its best alternative use. Maybe increasing their presence in a state where they already have a market share is creating more value. Sometimes it is more profitable to marginally increase a cost where a company already has an infrastructure. Where do they marginally get the most leverage on resources spent? Always ask: What is the change of value of taking a specific action? Where is it best to invest resources from a value point of view?

John's return from the investment was a meager 1%.

The 10-year $100,000 investment in the private partnership promised a yearly return of 15%. John's next best available investment at the time was a long-term U.S. government bond yielding 6%. 10 years later reality kicked in. He got back $110,000. His yearly return was only 1%. If he hadn't made the investment back then, but had earned returns comparable with the government bond, John would now have $179,000 (pretax) instead of the $110,000 (pretax). His real cost of doing this investment was $69,000. The money invested tied him in other ways. This doesn't include the mental stress he experienced during the ride.

We all have a lot of things we like: our spouse, job, house, car, investments, etc. When we decide whether to change something, we should measure it against the best of what we already have.

A complementary filter to evaluate alternatives is to list their respective pros and cons and then weigh all the points. Charles Darwin did this in order to decide whether to marry. Warren Buffett tells us what to look for in a spouse: "Look for someone who will love you unconditionally and will subtly encourage you to be better than you thought you can be."

We can also weigh alternatives the way Benjamin Franklin did. Make up a list of reasons for and against and assign them weights.

All decisions are not equally important. Some decisions have a greater influence on our lives. A decision we make today that will influence our lives ten years from now is far more important than one that will influence us only today. If we make a mistake in choosing the wrong vacation, the consequences over time will most likely be minor. But if, for example, we choose the wrong spouse, the wrong education, career, friends, or investment, it may haunt us a long, long time.