What is the opportunity cost
Opportunity cost is the comparison of an economic option with the next best option. These comparisons often appear in finance and economics when it comes to choosing between investment options. Opportunity cost attempts to quantify the effect of choosing one investment over another.
Here's how to calculate opportunity cost, some methods you can use to inform your investment decisions, and more.
What is the opportunity cost? Investors are always faced with the choice of how to invest for the highest or safest return. An investor's opportunity cost represents the cost of a particular alternative. If you choose one alternative over another, the cost of choosing that alternative becomes the opportunity cost.
Looking at opportunity cost is a factor not only in consumer decisions, but in many business decisions as well. Firms consider opportunity cost when making production, time management, and capital allocation decisions. An easy way to look at opportunity cost is to make trade-offs.
Trade-offs occur in any decision that requires giving up one option in favor of another. So if you choose to invest in government bonds instead of riskier stocks, there are trade-offs in the decision you make. Opportunity cost tries to assign a specific number to this trade-off.
How do you calculate opportunity cost?
Investors calculate the opportunity cost by comparing the returns on the two options. This can be done during the decision making process by estimating future returns. Alternatively, opportunity cost can be calculated retrospectively by comparing returns since the decision was made.
The following formula shows the calculation of the opportunity cost for investors comparing different investment returns:
How does opportunity cost work?
Investors try to calculate potential opportunity costs when making decisions, but in hindsight, opportunity cost calculations are more accurate. It's easier to compare the returns on chosen investments versus abandoned alternatives when you have actual numbers instead of estimates.
For example, suppose your aunt has to choose between buying stock in Company ABC and Company XYZ. He chose to buy ABC. One year later, ABC returns 3%, while XYZ returns 8%. In this case, you can clearly measure the opportunity cost of 5% (8% - 3%).
Investors often use opportunity cost to compare investments, but the concept can be applied in many different scenarios. For example, if your friend decides to take an entire year off and go back to school, the opportunity cost of that decision is the lost year's salary. Your friend compares the opportunity cost of lost wages with the benefits of higher education.
You can also consider opportunity cost when deciding how to spend your time. Let's say Attorney Larry charges $400 an hour. He decided to close his office one afternoon and paint it himself, thinking it would save him the expense of hiring a professional painter. However, the painting took four hours and cost him a fee of $1,600. Let's say a professional illustrator charges Larry $1,000 for a job. This means that Larry's opportunity cost is $600 ($1,600 - $1,000).
Please note that you are choosing to read this article instead of reading another article, checking your Facebook page, or watching TV. This choice led to a compromise. Your life is the result of your past decisions, which is basically the definition of opportunity cost.
Opportunity cost constraints
The main limitation of opportunity cost is the difficulty in accurately estimating future returns. You can study historical data to give you a better idea of an investment's performance, but you can never predict an investment's performance with 100% certainty.
Considering opportunity cost is still an important aspect of decision making, but it is not accurate until a choice has been made and you can go back and compare the performance of two investments.
While the concept of opportunity cost applies to any decision, it becomes difficult to quantify when considering factors that cannot be assigned dollar amounts. Let's say you have two investment options. One offers a conservative return but only requires you to tie up your money for 2 years, while the other won't let you touch your money for 10 years, but pays higher interest and takes on more risk. In this case, part of the opportunity cost will include the liquidity differential.
The biggest opportunity cost of liquidity is that you may miss out on great investment opportunities in the future because you can't put your money into another investment. This is a real opportunity cost, but it's hard to quantify in dollars, so it doesn't quite fit into the opportunity cost equation.
