The Cost of Opportunity

The Cost of Opportunity

October 24, 2022

As humans we tend to way underestimate the opportunity costs associated with taking various actions. We are keen to calculate the benefit of doing something, but often fail to accurately reflect what the true cost is for having taken that action. In his excellent book, Deep Work (which I highly recommend), author Cal Newport cites myriad examples where people focus on a very small benefit but ignore a much larger cost. For example, someone may spend an hour or more a day on social media and point out that during that time they were able to ‘keep up’ with someone from high school with whom they otherwise have no interaction. While there may be value in seeing how a long-lost friend is faring in life, the cost of this undertaking could easily be time not dedicated to current, deep friendships, as the time spent scrolling through Facebook is not spent calling a close friend or meeting a loved one for coffee and a true, meaningful interaction.

In the world of personal investing, the perceived benefit of taking action when stock prices are down (feeling better, gaining a sense of control, etc.) is often outweighed by cost (opportunities lost) of said action. Let’s examine some statistics and then tie this all together. First, we will start with examples of how quickly markets can recover from declines:

  • In 2009, the market closed up 23% after being down 28% at its lows. That means the market rallied 71% off its intra-year lows in a matter of months.
  • In 2020, the market rose over 75% from its lows to finish the year up 16%.

Had you sold in a panic during either of these declines, you would have missed in the blink of an eye some of the most rapid rallies the market has seen.

Now let’s examine how investors perform when they are out of the stock market for even a brief period of time (the opportunity cost for taking action and selling). A recent study of returns for the 15-year period between 12/31/06 and 12/31/21 found that:

  • If you were fully invested in the S&P 500 your annualized return was 10.66%.
  • If you missed just 10 of the best days in the market, your returns got cut in half to an annualized rate of 5.05%.
  • Missed the 30 best days (this is out of approximately 3,900 trading days) and your returns turned negative to an annualized rate of -1.18%.

When markets are declining, it seems like the bleeding will never stop. But facts indicate that the average bear market lasts a very short period of time (under 1 year), and the reality is that no one rings a bell when the proverbial pain is about to end. By the time financial pundits declare the ‘generational bottom’ is in (or the government states after the fact that we have been in a recession), the markets may easily have rallied 30%, 40%, or more from their lows. And those who sold stocks for cash they don’t need to spend for years, will once again regret their actions. Those who held tight and reinvested dividends at lower prices – or better yet added to their holdings on weakness – are rewarded (just as Buffett notes that money simply flows from the impatient to the patient during bear markets).

It is vital to be honest with yourself. I have known from the time I was a little kid that my brain (emotionally speaking) was not built to be a doctor. I have always been more than fine with my own pain, but would reflexively avert my eyes when witnessing scenes I am sure ER doctors run towards. But when it came to the proverbial blood in the street associated with stock market declines, that is when I was at my finest – and most calm. If you are tempted to sell otherwise high quality companies for the sole reason that their current ticker price is down – not because fundamentals have deteriorated or you need the money (in which case you should have planned years ago and set that cash aside) - then set up systems to keep yourself from taking such costly actions, or work with a highly disciplined Financial Advisor who can help you define and stick to a plan during good times and especially challenging ones.