Opportunity cost represents the potential benefit that a person, investor, or company misses out on in choosing one alternative over another. The idea of opportunity costs is an important economic concept in the sense of Investopedia.
Opportunity costs can easily be overlooked if not careful because, by definition, they are not visible. Understanding the potential missed opportunities that are missed by choosing one investment over another enables better decision-making.
Every decision we make as investors comes with an opportunity cost.
For example, if I invest in a portfolio of Dividend Aristocrats, my opportunity cost could be another investment within my opportunity set. For example, if my neighbor is Warren Buffett, I might have better invested in his investment partnership or Berkshire Hathaway.
Even the Omaha Oracle is governed by the same economic guidelines as we, ordinary investors. Every decision he makes comes with an opportunity cost that is foregone if one investment is preferred over another.
For example, in February 1958, he bought a home for $ 31,500. His family grew and his wife wanted to give birth to their third child.
As we discussed in a previous article on Buffett’s early days, Buffett rented a house at 5202 Underwood Street, Omaha, between 1955 and 1958 at $ 175 / month.
It is fascinating to read his opinion on living from this period:
In Omaha, I rented a house in 5202 Underwood for $ 175 a month. I said to my wife, “I would like to buy a house, but it’s like a carpenter selling his tools.” I didn’t want to use up my capital.
Buffett began his investment partnership in 1956 and was on his way to becoming one of the best investors in the world.
A dollar invested in his partnership in late 1957 and reinvested in Berkshire in 1970 would have turned into $ 113,349 by the end of 2020.
However, he and his wife decided to buy a house and closed in early 1958 according to this article: “Sam Reynolds House Sold To Warren Buffett,” Omaha World-Herald, February 9, 1958.
Using the returns from Buffett Partnership LTD between 1957 and 1970 and Berkshire Hathaway between 1970 and 2020, I was able to calculate the opportunity cost of owning his home versus the investment outlay.
I figured that if he’d just invested that $ 31,500 in early 1958, he would have made it $ 6,663,837,000. Check out my calculations from this table.
That’s over six and a half billion dollars. These are high opportunity costs.
It really was possible because, over a long period of time, Buffett managed to put money together with a high return.
For a common person investing in something like S&P 500, the opportunity cost of buying a home would have been nearly $ 18 million.
What makes it worse is that he paid cash for the house instead of taking out a mortgage. He put about 10% of his net worth into the house, according to a 1998 Berkshire Hathaway gathering video.
Incidentally, Buffett calculated the concept of opportunity cost for every dollar he’s spent since childhood. Few people think that way.
Mr. Buffett understood from the start that building wealth is not just about how much your money grows, but how long it grows.
He read a book that showed how a dollar compounded at a constant 10% per year can become $ 10.80 in 25 years and $ 117.40 in 50 years.
As a result, Warren began to look at time in a different way. Compounding married the present with the future. If a dollar were worth 10 a few years from now, the two were equal in his eyes.
“Do I really want to spend $ 300,000 on this haircut?” was his attitude. If Susie wanted to spend a little trifle For the sum of money he would say, “I’m not sure I want to blow $ 500,000 this way.” 48 But since Susie wanted to To spend money that he wanted to withhold and that he wanted Susie to be happy and to please her His personalities gradually interfered with a system of negotiation and trade.
In other words, he knew that every dollar he spends today could become $ 10, $ 100, or $ 1,000 in the future. That was helpful to him in assessing compromises. While various activities incur opportunity costs, if they made his wife happy, he had to do them. I’m pretty sure he would happily accept the daily cost of six cherry cokes over the past 70 years, for example because he had to drink water.
This shouldn’t really be news to dividend growth investors who understand that when you compound compounding, the greatest results will be seen at the end of your journey after a long time compounding.
A few weeks after purchasing the house, Buffett called it “Buffett’s Folly” in a letter to a friend, as described in “The Snowball”:
With the swing behind him, Warren realized it was time to leave a house that had little room for a house Family with two young children – one unusually energetic three and a half years old – and a third am Path. The Buffetts bought their first house. It was on Farnam Street, a Dutch cape set back on a large one Corner lot with evergreen views, next to one of Omaha’s busiest streets. While the largest house There was an unpretentious and charming atmosphere on the block, with dormer windows in the sloping shingle roof and one Eyebrow window. Warren paid $ 31,500 to Sam Reynolds, a local businessman, and was promptly named it’s “Buffett’s Folly”.
In his eyes, $ 31,500 was a million dollars after putting it together for about a dozen years. because he could invest it with such an impressive return. So he felt like spending one outrageous millions of dollars for the house.
After reading this article and seeing the calculation behind the $ 6.6 billion opportunity cost of buying Buffett’s house in 1958 for $ 31,500, you may be wondering if I included the whole picture in the calculation.
Once you’ve bought a house, you can live in it without paying rent.
I did not include the rental amount in the opportunity cost calculation. That’s because for the past 63 years I didn’t know what the rent would have been on his house.
While it is difficult to quantify the amount of money you could have saved in rent by buying a home for 63 years, it is even more difficult to quantify the amount of taxes, renovations, maintenance, etc. and landscaping, repairs around the house cost time and money. Outsourcing this job to a handyman also costs money and costs some of the savings you get from owning a clear and clear home. Since I didn’t want to make too many estimates, I didn’t even try.
However, I’m pretty confident that Buffett’s family spent more on the upkeep of this home than the amount they would have saved on rent. That’s because Buffett’s wife, Susan, spent $ 15,000 on renovations immediately after purchasing the home for $ 31,500. This was half the cost of the house!
Even illness and the demands of looking after a new baby and two young children could be don’t suppress their urge to decorate. When it came to life, she helped redesign the house in a cheerful, contemporary style Chrome-leather furniture and huge, bright modern paintings cover the white walls. The $ 15,000 The decoration bill was almost half the cost of the house itself, which “nearly killed Warren.” According to Bob Billig, a golf buddy.47 He never noticed colors or responded to visual aesthetics, and so it was Indifferent to the result, just seeing the outrageous bill.
In Buffett’s case, he’s not as frugal as anyone makes him out to be. In the 1950s, he spent $ 12,000 a year in Omaha. That’s the equivalent of just over $ 116,000 today. Still, $ 15,000 for a renovation would likely have cut his budget dramatically given his annual expenses.
If we wanted to calculate the opportunity cost of spending $ 31,500 on a home in early 1958 and spending $ 15,000 on renovations in 1958, I see total opportunity cost of $ 8.9 billion by the end of 2020.
For reference only, every dollar from 1956 has the same purchasing power as $ 9.72 / today. A dollar from 1958 today has the same purchasing power as $ 9.18.
In other words, this $ 31,500 house in 1958 costs $ 289,200 in today’s dollars. According to Zillow, his house costs about $ 650,000 today. However, that’s less than the $ 6.6 billion he would have had if he’d rented and invested the money instead.
This post will trigger a lot of people. That’s because owning a home is a sacred tradition that people should cling to and teach new generations to do. Few people think about the opportunity cost of actions taken through a rational lens without taking emotion, but instead focusing on the cold, hard, math facts. We are human after all.
But that’s exactly what Warren Buffett does … well … Warren Buffett.
However, if you want to improve your decision-making and become the best version of yourself, it can be helpful to incorporate the concept of opportunity cost into your tool belt.
Thank you for reading!
– Warren Buffett: America’s youngest early retiree
– Understand compounding and get rich late in life