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Investment Insights from the Economics Podium

 The Road Not Taken

Years ago, Thomas Carlyle branded economics "the dismal science."  Today, many interpret this label as apropos for a discipline which assigns such prominence to the notion that everything has a cost--a quite dreadful thought indeed, even for Americans who have so much more income and wealth than Carlyle must have ever imagined possible.

As every prudent college student affirms on the first Principles of Economics exam, "There's no such thing as a free lunch."  Of course the driving force behind the no-free-lunch principle is the notion of scarcity, which results when human wants exceed what is available.  Whenever our wants exceed availability, we must choose how our scarce resources will be allocated--and economics is the study of choice.

Robert Frost must have understood this fundamental economic principle.  When confronted with the choice between "two roads ... in a yellow wood," he recognized that the cost of choosing the road taken (the one less traveled) was the value that might have been gained from "the road not taken."  In a similar way, we all face decisions in every aspect of our lives, from the relatively trivial (omelet or pancakes?) to the not so trivial (how to choose our investments).  And the cost of any particular investment is the opportunity lost from the one not taken.  Put differently, the cost of any choice is the value of the one foregone (the next best alternative), with other relevant variables held the same.

 
 

"... a competent investor must continually perform cost-benefit analyses to ensure that the portfolio choices made in the past remain economically sound going forward."

In view of this, we can address what makes a specific investment, or a particular road for that matter, a good choice.  To an economist, a good investment is one that is better than the next best alternative.  In other words, the desirability of a given investment should be determined in comparison with other investment options.

Taking this reasoning one step further, the decision whether to hold or sell a stock should depend on a similar economic cost-benefit analysis.  Specifically, it is important to continually assess one's portfolio to ensure that the expected return from holding any given asset exceeds the cost of holding it, which is the expected return from the next best alternative investment.  Of course, taken in isolation, this approach could suggest that an investor hold only one stock (the one with the highest expected return, since presumably all others have lower returns).  However, the wisdom of diversification would lead a prudent investor to perform similar cost-benefit analyses comparing progressively lower expected return stocks until portfolio volatility is reduced to an acceptable level.

This logic goes a long way toward understanding why the stock of a successful company might be sold at a point when it is popular, perhaps reflected in a high price-earnings ratio.  Shouldn't one always continue to hold such a stock, rather than sell at a time when the stock is still performing fairly well?

Not necessarily.  There's nothing wrong with selling a stock if other investments exist that possess higher expected rates of return (controlling for other relevant variables, such as investment objectives, risk level and taxes).  In fact, economic principles clearly support such a way of thinking.  This aspect of investing is not only critical to success, but also demands extensive research to determine other possible investment options.

Choosing investments that, combined, offer slightly above average rates of return may be reasonably challenging for any investor.  However, the level of difficulty in identifying genuinely valuable long-term investments is greatly magnified by the knowledge, expertise and effort required to carefully canvas a sufficient number of alternatives.  Further, since market dynamics are such that the relative attractiveness of investments is changing constantly, a competent investor must continually perform cost-benefit analyses to ensure that the portfolio choices made in the past remain economically sound going forward.

"Vacuum investing"--choosing to hold a given stock as if in a vacuum of knowledge about the alternatives--is unlikely to result in satisfactory performance.  Successful investments should be selected because they are better than the rest, and as Robert Frost concluded, this will make "all the difference."

John R. Brock, Ph.D.
Vice President