Tuesday, April 13, 2021

Buffett's Folly and Opportunity Cost

Opportunity costs represent the potential benefits an individual, investor, or business misses out on when choosing one alternative over another. The idea of opportunity costs is a major concept in economics, as defined by Investopedia.

Opportunity costs can be easily overlooked if one is not careful, since they are not visible by definition. Understanding the potential missed opportunities foregone by choosing one investment over another allows for better decision-making.

Each decision we make as investors, carries an opportunity cost with it.

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 next door neighbor is Warren Buffett, I may have done better investing in his investment partnership or Berkshire Hathaway.

Even the Oracle of Omaha is subject to the same economic guidelines like us, ordinary investors. Every decision he makes carries with it an opportunity cost, which is the opportunity foregone by choosing one investment over another.

For example, back in February 1958, he bought a house for $31,500. His family was expanding, and his wife was about to give birth to their third child. 

As we discussed in a previous article on Buffett's earlier days, Buffett had rented a house on 5202 Underwood street in Omaha between 1955 and 1958 at a cost of $175/month. 

Today, this house is worth approximately $638,000 and has an estimated rent of $3906/month according to Zillow.

It is fascinating to read his opinion on housing from that time:

In Omaha, I rented a house at 5202 Underwood for $175 a month. I told my wife, “I’d be glad to buy a house, but that’s like a carpenter selling his toolkit.” I didn’t want to use up my capital.

Buffett had started 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 at the end of 1957, and then reinvested into Berkshire in 1970 would have turned into $113,349 through the end of 2020.

However, he and his wife decided to buy a house and closed at the beginning of 1958, according to this article: “Sam Reynolds Home Sold to Warren Buffett's,” Omaha World-Herald, February 9, 1958.



Using returns from Buffett Partnership LTD between 1957 - 1970 and Berkshire Hathaway between 1970 to 2020, I was able to calculate the opportunity cost of owning his home, versus staying invested.

I calculated that if he had simply invested that $31,500 in early 1958, he would have managed to turn it into $6,663,837,000. Check my calculations from this spreadsheet.

That's over six and a half billion dollars. That's a steep opportunity cost.

It was truly possible because Buffett managed to compound money at a high rate of return for a long period of time. 

For a normal person investing in something like S&P 500, the opportunity cost of buying a house would have been something close to $18 million.

What makes it worse is that he paid cash for the house, rather than taking a mortgage. He put about 10% of his net worth in the house, according to a 1998 Berkshire Hathaway meeting video.

By the way, Buffett has calculated the concept of opportunity cost of every dollar he spends since an early age. Few people think this way.

From the earliest age, Mr. Buffett has understood that building wealth depends not only on how much your money grows, but also on how long it grows.

He read a book that showed how a dollar compounding at a steady 10%/year can turn into $10.80 in 25 years and $117.40 in 50 years.

As a result, Warren began to think about time in a different way. Compounding married the present to the future. If a dollar today was going to be worth 10 some years from now, then in his mind the two were the same.

“Do I really want to spend $300,000 for this haircut?” was his attitude. If Susie wanted to spend some trifling sum of money, he would say, “I’m not sure I want to blow $500,000 that way.”48 But since Susie wanted to spend money that he wanted to withhold, and since he wanted Susie to be happy and she wanted to please him, their personalities were gradually meshing into a system of bargaining and trades.

In other words, he knew that each dollar he spends today could turn into $10 or $100 or $1000 in the future. That was helpful for him in evaluating trade-offs. While there is opportunity costs to various activities, if they made his wife happy, he had to do them. I am pretty sure that he would gladly accept the daily cost of six cherry cokes over the past 70 years, over having to drink water for example.

This shouldn't really be news for Dividend Growth Investors, who understand that with compounding, the largest results are visible at the end of your journey, after a long time of compounding.

A few weeks after buying the house however, Buffett called it "Buffett's Folly" in a letter to a friend, as discussed in " The Snowball":

With momentum behind him, Warren realized it was time to leave a house where there was barely room for a family with two young children—one an unusually energetic three-and-a-half-year-old—and a third on the way. The Buffett's bought their first house. It stood on Farnam Street, a Dutch Cape set back on a large corner lot overlooked by evergreens, next to one of Omaha’s busiest thoroughfares. While the largest house on the block, it had an unpretentious and charming air, with dormers set into the sloping shingled roof and an eyebrow window. Warren paid $31,500 to Sam Reynolds, a local businessman, and promptly named it “Buffett’s Folly.” 

In his mind $31,500 was a million dollars after compounding for a dozen years or so, because he could invest it at such an impressive rate of return. Thus, he felt as though he were spending an outrageous million dollars on the house.

After reading this article, and seeing the calculation behind the $6.6 billion opportunity cost for Buffett's purchase of a house in 1958 for $31,500, you may actually wonder whether I have included the whole picture in the calculation.

After all, once you buy a house, you get to live in it, without paying rent.

I didn't include the amount of rent in the calculation of the opportunity cost. That's because I didn't know what the rent would have been for his house over the past 63 years.

While it is hard to quantify the amount of money you could have saved on rent for 63 years by buying a house, it is even harder to quantify the amount of taxes, renovations, upkeep etc.  For example, upgrading the house, changing roofs, and landscaping, fixing things around the house cost time and money. If you outsource this task to a handyman, this will cost money too, and eat into some of the savings that you generate by owning a house free and clear. Since I didn't want to make too many estimates, I didn't even try.

However, I am pretty confident that Buffett's family spent more in upkeep on this house than the amount they would have saved on rent. That's because immediately after buying the house for $31,500, Buffett's wife Susan spent $15,000 on renovations. This was half the cost of the house!

Even illness and the demands of caring for a new baby and two small children could not suppress her urge to decorate. As it sprang to life, she redid the house in cheery contemporary style, with chrome-and-leather furniture and huge, bright modern paintings covering the white walls. The $15,000 decorating bill totaled almost half of what the house itself had cost, which “just about killed Warren,” according to Bob Billig, a golfing pal.47 He didn’t notice colors or respond to visual aesthetics and so was indifferent to the result, seeing only the outrageous bill.

In Buffett's case, he is not as frugal as everyone makes him out to be. He spent $12,000/year in the 1950s in Omaha.  That's equivalent to a little over $116,000 today. Still, spending $15,000 on a renovation would have likely sunk his budget dramatically, given his annual level of spending. 

If we wanted to calculate the opportunity cost of spending $31,500 on a house in early 1958, coupled with spending $15,000 on renovations in 1958, I see a total opportunity cost of $8.9 billion by the end of 2020.

According to public property records, there was a remodeling done in 1989. I am not versed in residential tax assessor language, but it looks like the tax assessment shows close to $800,000 in improvements. 

Just for reference, each dollar from 1956 has the same purchasing power as $9.72/ today. A dollar from 1958 has the same purchasing power as $9.18 today.

So in other words, that $31,500 house in 1958 costs $289.200 in today's dollars. According to Zillow, his house costs about $1,390,000 today and would rent for $7,119/month. Still, this is lower than the $6.6 billion he would have had, if he rented instead, and invested the money.

This post will trigger a lot of people. That's because owning a home is a sacred tradition, which people are expected to hold on to, and teach the new generations about. Few people think about the opportunity cost of actions they partake, through a rational lens, without taking any emotions but focusing on the cold, hard, mathematical facts. We are human after all.

But that's what makes Warren Buffett.. well.. Warren Buffett.

That being said, if you want to improve on your decision making, and become the best version of yourself, it may be helpful to incorporate the concept of opportunity cost in your toolbelt. 

Thank you for reading!

Relevant Articles:

- Warren Buffett: America's Youngest Early Retiree

- Understanding Compounding and Getting Rich Late in Life



12 comments:

  1. A couple of thoughts. One, there is the time value of money. A dollar today is more valuable than a dollar in the future, and the future cannot be predicted with any accuracy, especially over longer time periods. So, if buying a house today makes good economic and personal sense, do it. We do live in the present and need to enjoy our time. Second, as the future is unpredictable, picking a particular point in time for comparison to the present can lead to false expectations. Looking backward, as you have done, creates accuracy. Looking forward creates uncertainty. Your own philosophy, which I fully share, of living off of mostly predicatble dividends vs. having to sell assets to gain capital when the value of those assets is unpredictable, is roughly equivalentto not using capital to purchase something needed and worthwhile in hopes that that capital grows substantially. There is an opportunity cost for not owning and enjoying that asset (house, whatever) while saving money and forgoing the enjoyment. Save for a rainy day and gather ye flowers while you may.

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    1. You are always paying an opportunity cost, whether you realize it, or not. It is not easily calculatable of course, but it is always there.
      You make your own trade-offs of course and choose what is best for you. However you would still be subject to opportunity cost.
      There is an opportunity cost of owning a house. You can be renting and potentially having more free time and potentially having more to invest more. The opportunity cost of renting is that you would have more control with housing (as in tear walls down, install a swimming pool in your backyard etc).
      And as you mentioned, it is not guaranteed that your investments would do well. If you rented and invested in General Motors, your opportunity cost would have been owning a decent house free and clear ( minus renovations, taxes, maintenance etc).
      But you can still enjoy your time with a rented house. About one-third of the US population rents.
      It’s interesting that you say the future is unpredictable. That’s actually a reason to be renting, rather than owning, since renting offers more flexibility, especially if you are working. Why put money towards an illiquid asset that would be hard to offload if the area you live in suffers from loss of employers, national disasters etc?

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    2. Renting vs. buying, leasing vs. buying, cash vs. credit, etc. can be viewed as economic decisions. I choose not to take that view. To me they are lifestyle decisions. I have owned many houses, always viewing the house as a home for me and my family, not as an investment. I have owned many cars, preferring to buy rather than lease. But everyone's world view is different, and no one can say their view is the only "correct" one.

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    3. Everything you do has an opportunity cost

      You can choose to not think about it, and to ignore it

      But that doesn't mean it goes away

      I have apples and oranges on my table. If I eat an apple, I will get full and won't be able to eat an orange. Thus, the opportunity cost of eating an apple is eating an orange. And vice versa.

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  2. I think by not calculating the rent, you have left out a big part of the picture. Especially, the part about rent increasing. Owning a home is also more than an investment. It s a home, a stable home. You are not guaranteed that the house you are renting will remain available. And how many people actually have the discipline to actually invest the difference. Buffet would have, but most people would not.

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    1. Actually, I am being overly conservative by ignoring rent. That's because I also ignored renovations, taxes, upkeep, maintenance. These expenses were much higher than what they would have paid in rent.

      Did you miss the part where Buffett's wife spent $15,000 on renovations/decorations in 1 year, that's on a $31,500 house? That's equivalent to 7 years of rent in their old place

      They have made major renovations since, plus you'd have your normal upkeep as well.

      Just looking at how quickly they spent so much, I would tell you that buying definitely costed them a lot more than renting would have.

      Of course, there is opportunity cost associated with renting. But you would have an opportunity cost, no matter which outcome you choose. You have to make the trade-off that is right for you. If it makes you happy, who cares if you are not $18M or $6B richer?




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  3. I enjoyed this article as I do most of your content! This has been a big dilemma for me as I approach my upper 20s and am looking at buying a home vs continuing to rent. My qualm about renting is that the price you are paying in rent includes the owner’s mortgage+other maintenance costs+margin for the landlord. Being a landlord is often times extremely lucrative for that exact reason, I don’t think it’s a 1:1 monthly cost for renting vs owning from what I’ve seen. Looking through Zillow and other sites, the monthly payments you make from owning (mortgage+taxes+insurance+other random stuff) is still almost always much cheaper than renting a similar quality property. Especially after you pay off the mortgage your monthly commitment will be even less than what it is for rent. Now the big caveat there of course is that you will need a larger up front cost in terms of a down payment and I can certainly see that as an opportunity cost, but if you are paying hundreds/thousands more per month in rent vs the monthly cost of owning the home would the calculus switch the other way over the long term? Another point I wanted to make with your example here is Mr. Buffet put in almost ~50% worth of renovations at the outset of buying his home. I think purchasing a home knowing that that kind of input for renovations being necessary is in itself a bad investment.

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    1. Opportunity cost goes beyond just buying versus renting of course. I just used the example with Mr. Buffett to illustrate a point.

      I wish you good luck with your decision!

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  4. Just saw that your comment section is available. I think Buffet also mentioned that a mortgage loan would be a good decision here, this way you lower you equity participation by 5×10 times and that makes the math different. Since mortgage payment = rent more or less you should not count mortgage payments. Then you have mortgage fully paid, initial investment 3-6k$ = 1,3m$. Yes its still vs 0,6-1,2 bn end result for investment, but there are hundereds that have loss all and few that have such investment result. I soubg that everyone can do the Buffet result of ×200k increase in 60y thats 22% CAGR. You will not get that return in todays yields when investment became a tottal commodity available for everyone. Tycoons in XIX century made even more impressive returns.

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    1. Spending the money in cash on a house had a high opportunity cost to Buffett. Even an index fund would have been better.

      From a historical perspective, it's been better to take a loan to buy a house and invest the difference, versus buying a house in cash ( few of us are able to buy a house in cash of course)

      But there is an opportunity cost there too. If you pay in cash, you own the house free and clear (minus taxes, maintenance, upkeep etc). The opportunity cost is that this money could have done been if it were invested elsewhere. Plus, it is not easy or cheap to access the home equity of a fully paid for house if you need the money.

      Now if you took a loan, and invested the difference in stocks, you may do pretty well. But there is still an opportunity cost, in that you could have just paid the house off. If you selected the wrong investments, you may have been better off buying the house outright.

      While I calculated the opportunity cost for Buffett's decision to buy a house in cash, rather than invest the money, the reality is that a lot of times the decisions are not easy to calculate. And a lot of times the opportunities are not visible, you have to actively think about it. The opportunity cost still exists however - if you take one job, that could be at the expense of taking another job. Or if you marry one person, there is an opportunity cost to that too ;-)

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  5. Please recall the greatest financial setback for adults is usually DIVORCE. "Happy wife, happy life". I humbly suggest if you refute this then you are most likely not married:))

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    1. Yet, Buffett's wife eventually left him

      All the spending in the world did not make her happy apparently

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