The Hindu Business Line : Of stocks and opportunity cost

MY FRIEND hired a professional money manager to invest in equity. The money manager gave my friend a list of stocks but suggested that he buy them at higher levels.

My friend argued that if a stock were worth buying at a higher price, it should obviously be better buying them cheap. The money manager disagreed. What could be her rationale?

Suppose the professional manager suggested that my friend buy Reliance Industries only if the stock moves above Rs 800 and not at Rs 780. The cost of buying later is Rs 20 per share.

But what is the cost for buying at Rs 780? It is the opportunity lost by not investing in other stocks because the capital may be locked up in Reliance for a longer time.

The reason is that at Rs 780, the money manager may be unsure if the stock will move up. At Rs 800, she is more certain about its upmove.

In technical analysis parlance, Rs 800 is a breakout level. A stock typically moves up faster on breakouts. This lowers the opportunity cost, as the stock may reach the price target faster.

But does not basic economics tell you that buying goods cheap is better?

True, but buying equity is different from buying other goods. How?

You are better off buying bread at a lower price because the utility derived from consuming a loaf remains the same. You do not consume stocks. You sell them for a higher price at a later date.

A stock will not move up just because it is selling cheap. It moves up when demand is higher than supply. And that typically happens on price breakouts.

That, perhaps, was the money manager's rationale.

(The author is Head, Research, Navia Markets.)

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