This is the cost of choosing the wrong opportunity

By Kim Iskyan

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 is the value of the alternative. Investors face opportunity cost in every investment decision.

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), a U.S. data storage company. Earnings were surging, the company's growth outlook was exceptional and analysts were pounding the table to buy.

You did some research and bought at US$6.90 per share. But things didn't go well and one year later, Quantum Corp traded at US$4 per share, a loss of 58 percent. (And to make matters worse, you didn't adhere to your trailing stop-loss - so you took the entire loss.)

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 it at US$12.70 a share. The stock, and market, seemed boring, and a major analyst had just downgraded HPE. So you passed.

But twelve months later, Hewlett Packard was at US$18.70 per share, for a gain of 44.7 percent (not including a dividend of around 3 percent).

Your US$10,000 Quantum investment is now worth US$4,200. 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.

But it gets worse. Add that to the US$4,700 you did not receive by deciding not to invest 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. However, as the graph below shows, an investor would have had many opportunities to sell Quantum shares and buy Hewlett Packard shares. If the investor admitted that he had chosen the wrong stock and swapped the "dead money" in Quantum to buy Hewlett Packard, he would have had a lower opportunity cost.

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 where 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 evidence to the contrary.

Seasoned investors always 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. 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.

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 maintaining 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.

 

Kim Iskyan
Kim Iskyan is the publisher of Stansberry Churchouse Research, an independent investment research company based in Singapore and Hong Kong that delivers investment insight on Asia and around the world. Kim has nearly 25 years of experience as a stock analyst, hedge fund manager, political risk consultant, and financial commentator in more than half a dozen emerging and frontier markets. He's been quoted in the Economist, The New York Times, the Wall Street Journal, Barron's, and Bloomberg, and has appeared on Fox Business News, China Central Television, and Bloomberg TV, and has written commentary for the Wall Street Journal, Slate.com, Salon, TheStreet.com, breakingviews.com, and other publications. For more of his insights, Click here to sign up to receive the Asia Wealth Investment Daily in your inbox every day, for free.

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