Howard Marks on Opportunity Cost

one can easily see that the piece being given up will return concrete benefits that can be clearly calculated.” In other words, I put a piece in clear jeopardy, but I do this so that I’ll be able to take one of yours of greater value. • Others are deemed “real” sacrifices, where “. . . giving away a piece offers gains that are neither immediate nor tangible. The return on investment might be controlling more space, creating an assailable weakness in the opponent’s position, or having more pieces in the critical sector of attack.” The analogy to investing begins to become clear. Buying a 10-year U.S. Treasury note is a modest or “sham” sacrifice. You give up the use of your money for ten years, but that’s only an opportunity cost, and accepting it brings the certainty of interest income. Most other investments involve real sacrifices, though, where the risk of loss is borne in pursuit of “gains that are neither immediate nor tangible.” Ashley goes on to speak of sacrifice in risk/return terms that are familiar to investors. He describes his mother’s decision to leave him (at age two) and his two siblings in Jamaica and travel to the U.S. in search of a better life for herself and for them. She reached her goal a decade later and was able to bring her kids to the U.S., where they would find success in a variety of fields: It did not have to turn out that way. It did because she was willing to stomach the key aspect of making real sacrifices: the willingness to take risks.

The effects of low interest rates are multi-faceted and ubiquitous, yet frequently overlooked. I became more conscious of them as I read The Price of Time, and I want to catalog them here: i. Low interest rates stimulate the economy Everyone knows that when central banks want to stimulate their countries’ economies, they cut interest rates. Lower rates reduce costs for businesses and put money into the hands of consumers. For example, since most people buy cars on credit or lease them, lower interest rates make cars more affordable, increasing demand. The result is typically good for automakers, their suppliers, and their workers, and thus for the economy in general. It’s important to realize that easy money keeps the economy aloft, at least temporarily. But low interest rates can make the economy grow too fast, bringing on higher inflation and increasing the probability that rates will have to be raised to fight it, discouraging further economic activity. This oscillation of interest rates between extremes can have effects and encourage behavior that natural/neutral rates (see p. 13) would be less likely to induce. ii. Low interest rates reduce perceived opportunity costs Opportunity cost is a major consideration in most financial decisions. But in low-interest-rate environments, the rate earned on cash balances is minimal.

Thus, you don’t forgo much interest by withdrawing money from the bank to buy a house or boat (or make an investment), which makes doing so seem painless. For example, if someone’s thinking about taking $1 million out of savings for a purchase at a time when savings accounts pay 5% interest, they’re likely to understand that doing so will cost them $50,000 per year in forgone income. But when the rate is zero, there is no opportunity cost. This makes the transaction more likely to occur. iii. Low interest rates lift asset prices In finance theory, the value of an asset is defined as the discounted present value of its future cash flows. We discount future cash flows when calculating present value because we must wait to © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Under easy-money conditions, long-dated bonds may appear particularly desirable; since the yield curve usually slopes upward, they typically offer higher yields. It should be noted, however, that long bonds are more rate-sensitive than short ones, meaning their prices change more in response to a given change in interest rates. As a result, the higher yields on more- volatile long bonds can attract capital in times of low rates, just when the odds usually favor a subsequent increase in yields (and thus a rapid decline in long bond prices). It seems to me that there’s often a similar movement of capital toward “long stocks” when interest rates are low. By this I mean the stocks of companies believed to have many years of rapid growth ahead. For these companies, more of the projected cash flows are, by definition, in the distant future. Yet, investors may become more attracted to these stocks when rates are low because they want the higher returns that such rapid growth would bring, and there’s less opportunity cost associated with the long wait for the relevant cash flows. (These sound like Hayek’s “projects with more distant payoffs.” See the quote on the previous page.) Just as the prices of longer bonds fluctuate more in response to a given change in interest rates, so-called “growth stocks” usually rise more than others in times of easy money and fall more when money dries up. The former was certainly the case in late 2020 and in 2021 . . . and the latter in 2022.

I want to be clear that taking a sea-change view does not mean refusing to invest. It means calibrating the price you pay for the risk you assume to the new reality rather than the old one. When risk premia were historically thin, demanding more is a defensive posture, not an offensive one. The opportunity cost of holding cash has risen as rates have moved higher, but the opportunity cost of locking capital into illiquid commitments at thin spreads has fallen, because those spreads no longer compensate for the regime change. The hardest part of contrarian investing is not the act of going against the crowd — it is the patience required to wait for the crowd to come around. In the meantime, periods of repricing typically produce dispersion. Some assets turn out to have been mispriced conservatively; others reveal that the assumptions behind them were heroic. Distinguishing between the two is where value is created. The investor who expects a return to 2021 conditions may under-prepare for what is actually coming. The investor who expects a continued regime shift may end up positioned better but also needs to remain humble about timing. I do not know when the cycle resolves; I do know that the regime assumptions in prices look different from the regime assumptions I grew up with.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: What’s the downside? How could this be a mistake? • First, individual borrowers can default and fail to pay. It’s the main job of the credit manager to weed out the non-payers, and history shows it can be done. Isolated defaults are unlikely to derail a well-selected and well-diversified portfolio. And if you’re worried about a wave of defaults hitting your credit portfolio, think about what the implications of that environment would be for equities or other ownership assets. • Second, by their nature, credit instruments don’t have much potential for appreciation. Thus, it’s entirely possible that equities and levered investment strategies will surprise on the upside and outperform in the years ahead. There’s no denying this, but it should be borne in mind that the “downside risk” here consists of the opportunity cost of returns forgone, not failing to achieve the return one sought. • Third, bonds and loans are subject to price fluctuations, meaning having to sell in a weak period could cause losses to be realized. But credit instruments are far from alone in this regard, and the magnitude of the fluctuations on “money-good” bonds and loans is constrained significantly by the magnetic “pull to par” exerted by the promise of repayment upon maturity. • Fourth, the returns I’ve been talking about are nominal returns.

The second-level thinker always asks what is already in the price. When interest rates were collapsing for forty years, virtually every long-duration asset repriced higher in concert — bonds, equities, real estate, fine art. The rising tide lifted all boats and made asset selection look less important than it actually was. Now that the tide has turned, the cost of being wrong about an asset's quality or durability has risen substantially. I have been frank that the era of free money distorted the relationship between price and value. Capital flowed to strategies that promised growth at any price, to private structures that offered illiquidity premiums whether they were earned or not, and to fee structures that rewarded asset gathering more than return generation. The opportunity cost of staying in those arrangements is now visible: capital tied up in below-market illiquid commitments cannot be redeployed into the dislocations that follow a credit tightening. The discipline that matters now is the one Oaktree was built around — patient, credit-anchored, second-level thinking that asks not just whether an asset is good but whether it is cheap given what the consensus already believes. In a world of repriced risk, the answers tend to be more selective and more time-sensitive than the previous decade accustomed us to.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: portfolio rather than making the change? Or perhaps you don’t plan to reinvest the proceeds. In that case, what’s the likelihood that holding the proceeds in cash will make you better off than you would have been if you had held onto the thing you sold? Questions like these relate to the concept of “opportunity cost,” one of the most important ideas in financial decision-making. Switching gears, what about the idea of selling because you think a temporary dip lies ahead that will affect one of your holdings or the whole market? There are real problems with this approach: • Why sell something you think has a positive long-term future to prepare for a dip you expect to be temporary? • Doing so introduces one more way to be wrong (of which there are so many), since the decline might not occur. • Charlie Munger, vice chairman of Berkshire Hathaway, points out that selling for market-timing purposes actually gives an investor two ways to be wrong: the decline may or may not occur, and if it does, you’ll have to figure out when the time is right to go back in. • Or maybe it’s three ways, because once you sell, you also have to decide what to do with the proceeds while you wait until the dip occurs and the time comes to get back in. • People who avoid declines by selling too often may revel in their brilliance and fail to reinstate their positions at the resulting lows.

“The idea that [Amazon] will receive hundreds of millions of dollars in tax breaks at a time when our subway is crumbling and our communities need MORE investment, not less, is extremely concerning to residents here,” she wrote . . . Reached by telephone on Thursday, Ocasio-Cortez called the Amazon deal “dressed- up trickle-down economics.” “What we’re seeing here is a complete public cost for a private corporate benefit,” she told me. “When you give a three-billion-dollar tax break to the richest company in the world, that means that you’re giving up our schools. You’re giving up our infrastructure. You’re giving up our community development.” In other words, there is an opportunity cost to luring the world’s richest man by letting him free-ride on the public services that other New Yorkers must pay for. Although the majority of New Yorkers supported the deal in polls, the combined forces in opposition were sufficient to turn Amazon away. In a statement, the company said: For Amazon, the commitment to build a new headquarters requires positive, collaborative relationships with state and local elected officials who will be supportive over the long term. That doesn’t sound unreasonable. But Amazon’s decision not to go forward was cause for victory celebrations on the left. City Councilman Jimmy Von Bramer said: Even when we were faced with the richest man in the world and the richest company in the world, we did not buckle. Amazon doesn’t need our $3 billion . . .

” The outlook is not so bad, and asset prices are not so high, that one should be in cash or near-cash. The penalty in terms of likely opportunity cost is just too great to justify being out of the markets. But for me, the import of all the above is that investors should favor strategies, managers and approaches that emphasize limiting losses in declines above ensuring full participation in gains. You simply can’t have it both ways. Just about everything in the investment world can be done either aggressively or defensively. In my view, market conditions make this a time for caution. September 26, 2018© 2018 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

The market is a big arena where optimists and pessimists engage in a tug of war. When optimism is rising relative to pessimism, meaning more money wants to get put to work than wants to exit, prices rise (and vice versa). The market has been going roughly sideways for the last few months, meaning the two camps are in rough balance. But that doesn’t mean they’re not both out there. Everyone had a great year in 2003, and “they” seem to think it’s going to continue. They’re cheered by signs of economic recovery, corporate profit gains and job growth. “We,” on the other hand, worry about the things that could result in disappointment, like the lackluster economic and employment gains, and the trade and budget deficits. We also worry about structural issues, such as the US’s reliance on foreign capital, the questionable outlook for the dollar, and the consumer’s high level of indebtedness and low level of savings. Lastly, we feel the possibility of domestic terrorism hangs out there like a sword of Damocles. A particularly striking difference can be seen in current attitudes toward interest rates. Rates do a great deal to influence the vitality of the economy and the price and relative attractiveness of market sectors. Today’s low rates encourage growth and borrowing. They also reduce the competition to stocks posed by bonds and money market securities.