Managing Portfolio Cash Flow. Cash is the most Important determinant of Opportunity Cost

Most important determinant of opportunity cost:  Cash portion of your portfolio

If you hold cash, you are able to take advantage of opportunities during market declines.

If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels.

This creates an opportunity cost, the necessity to forego future opportunities that arise.

If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.

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.



Managing portfolio cash flow

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 the 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.



Hedging

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.