You’re opportunity cost is your next best option. Opportunity cost is best understood in the context of evaluating two different choices. The opportunity cost for investment A is the return you would have made on investment B. Opportunity costs are real, and should always be considered when making investment decisions.

Opportunity cost neglect is a common behavioral mistake. Very few people actually consider their opportunity cost when making financial decisions. For example, the cost of holding a “cash buffer” in a checking account is really high. You could be earning 4% interest in a savings account instead. The cost of holding a “rainy day fund” in a savings account is even higher. You could be earning 10% on average in an index fund instead. And the cost of buying a passive index fund is even higher if you can outperform the market buying individual stocks. When you look at it this way, you could be losing a lot of money by not considering your opportunity cost.

Holding a stock has an opportunity cost. Every investment has an opportunity cost that should be considered a risk. Missing out on a better investment is just as risky as losing money. Opportunity cost is usually captured in the discount rate during valuation. The discount rate for an equity investment is the risk free rate (T-Bills) plus an equity risk premium. In practice, most analysts use the average annual performance of the S&P 500 (~10%), sometimes adjusting for the risk profile of the stock. However, using this heuristic to value a company is wrong in our view. You should always use a discount rate that reflects your opportunity cost (your next best investment), which is usually higher than the ~10% used by most analysts. You are more accurately capturing your risk under this approach, but the downside is that it makes valuation more subjective.

Your opportunity cost starts to outpace your returns if you hold a stock for too long. There is less upside remaining as the stock price approaches your estimate of fair value. New investments become relatively more attractive as your investment thesis plays out and its return potential diminishes. Holding a stock for too long can actually result in losing money after considering your opportunity cost (which is always the return on your next best investment). Minimizing your opportunity cost requires rebalancing your portfolio with new investment ideas that have a higher return potential.