Ways to Limit Opportunity Cost - Most Important is holding Part of your Portfolio in Cash

The most important determinant of whether investors will incur opportunity cost is whether or not part of their portfolios is held in cash.  

• Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities. 

Investors can manage portfolio cash flow (defined as the cash flowing into a portfolio minus outflows) by giving preference to some kinds of investments over others.  Portfolio cash flow is greater for securities of shorter duration (weighted average life) than those of longer duration.  Portfolio cash flow is also enhanced by investments with catalysts for the partial or complete realization of underlying value.

• Equity investments in ongoing businesses typically throw off only minimal cash through payment of dividends.  
• The securities of companies in bankruptcy and liquidation, by contrast, can return considerable liquidity to a portfolio within a few years of purchase.  
• Risk-arbitrage investments typically have very short lives, usually turning back into cash, liquid securities, or both in a matter of weeks or months.

An added attraction of investing in risk-arbitrage situations, bankruptcies, and liquidations is that not only is one's initial investment returned to cash, one's profits are as well.

Another way to limit opportunity cost is through hedging. 

• A hedge is an investment that is expected to move in a direction opposite that of another holding so as to cushion any price decline. 
• If the hedge becomes valuable, it can be sold, providing funds to take advantage of newly created opportunities .

Value Investors are absolute-performance oriented and are willing to hold cash when no bargains are available

Value investors, by contrast, are absolute-performance oriented; they are interested in returns only insofar as they relate to the achievement of their own investment goals, not how they compare with the way the overall market or other investors are faring. Good absolute performance is obtained by purchasing undervalued securities while selling holdings that be come more fully valued. For most investors absolute returns are the only ones that really matter; you cannot, after all, spend relative performance.

Absolute-performance-oriented investors usually take a longer-term perspective than relative-performance-oriented investors. A relative-performance-oriented investor is generally unwilling or unable to tolerate long periods of underperformance and therefore invests in whatever is currently popular. To do otherwise would jeopardize near-term results. Relative-performance-oriented investors may actually shun situations that clearly offer attractive absolute returns over the long run if making them would risk near-term underperformance. By contrast, absolute-performance-oriented investors are likely to prefer out-of-favor holdings that may take longer to come to fruition but also carry less risk of loss.

One significant difference between an absolute- and relative-performance orientation is evident in the different strategies for investing available cash. Relative-performance-oriented investors will typically choose to be fully invested at all times, since cash balances would likely cause them to lag behind a rising market.  Since the goal is at least to match and optimally be at the market, any cash that is not promptly spent on specific investments must nevertheless be invested in a market-related index.

Absolute-performance-oriented investors, by contrast, are willing to hold cash reserves when no bargains are available.

• Cash is liquid and provides a modest , sometimes attractive nominal return, usually above the rate of inflation. 
• The liquidity of cash affords flexibility, for it can quickly be channeled into other investment outlets with minimal transaction costs. 
• Finally, unlike any other holding, cash doe s not involve any risk of incurring opportunity cost (losses from the inability to take advantage of future bargains) since it does not drop in value during market declines.

Be willing to hold cash reserves when no bargains are available

Absolute-performance-oriented investors, by contrast, are willing to hold cash reserves when no bargains are available.

Cash is liquid and provides a modest, sometimes attractive nominal return, usually above the rate of inflation.

The liquidity of cash affords flexibility, for it can quickly be channelled into other investment outlets with minimal transaction costs. 

Finally, unlike any other holding, cash does not involve any risk of incurring opportunity cost (losses from the inability to take advantage of future bargains) since it does not drop in value during market declines