What is Opportunity Cost in Economics?
Ever had to make a choice between two things? Perhaps you had to choose between ordering in a pizza and making a homemade dinner. Or maybe you sold your shares in a stock instead of holding onto them for a few more years. With every decision you make, there’s always a resulting opportunity cost. This is because you’ll always miss out on something by choosing one option over another.
The concept of opportunity cost is important for both investing and most other decisions we make. At the most basic level, opportunity cost is a common-sense concept economists and investors frequently explore. From an investor’s perspective, opportunity cost is the potential gain you miss out on when you commit to one investment choice over another. Read further to learn more about opportunity cost, how it works, how to calculate it, and how you can use it to make informed investment decisions.
What Is Opportunity Cost?
Opportunity cost is the value of what you lose or have to give up when you select between two or more alternatives. More precisely, you could look at it as the value of the path not taken. With every decision, you decide that the choice you’re making will have better results, regardless of what you may miss out on. If you’re an investor, opportunity cost implies that you’ll always stand to gain or lose, in the short or long term, based on the investment choices you make.
Technically, opportunity cost isn’t an exact measure, but you can quantify it by estimating the future value of what you chose not to receive and comparing it with the value of your choice. For instance, selling shares immediately may secure immediate gains, but you might miss out on additional gains if you held your investment longer.
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How Opportunity Cost Works
When confronting a financial decision, you always attempt to weigh the return you’ll receive from the option you choose. Economics helps us to better define opportunity cost, which is the difference between the expected return on the investment option you forgo and the investment option you choose.
You can calculate investment returns by getting the expected returns of all your options. Consider, for example, an exchange-traded fund (ETF) that has an expected return of 15%, compared to a real estate investment that has a 10% return. The opportunity cost of choosing to invest in real estate is 5%. This means that you’ll miss out on a 5% return if you decide to invest in real estate instead of an exchange-traded fund.
To determine opportunity cost, you’ll need to consider several other factors besides the flat returns. One such factor is the level of risk associated with each choice. Generally, the higher the risk of losing money on an investment, the greater the expected return. Even so, it’s still difficult to compare the opportunity costs of high-risk investments to those with a low risk.
Opportunity Cost of Capital
The opportunity cost of capital reveals the existence of other opportunities that you can invest in now and in the future. When assessing profitability, investors are always looking for the option likely to provide the greatest return. You might not understand the whole premise, but practically every decision will involve some trade-off. Ideally, you can’t invest capital in two places at the same time.
An explicit cost is the direct, out-of-pocket payment an investor makes; for example, to buy shares of a stock or its options, or spend the money to remodel a rental property. When you remodel your rental property, for example, you could spend $100 on labor and other fixtures. In this case, your explicit cost is $100. Now, the opportunity cost is what you could have done with the $100 if you had not improved your property. You could have channeled it to an IRA and saved for your retirement.
Implicit costs are not direct costs to you. They are the opportunity you give up to create income through your resources. If you own a second home used for vacations, the implicit cost is the rental income you could earn by leasing it when you’re away. Although using the vacation home comes at no direct cost, you’re giving up the opportunity to earn income by not leasing it out.
How to Calculate Opportunity Cost
As mentioned earlier, opportunity cost is the difference between the expected return on the forgone option (FO) and the chosen option (CO). The formula can be written as follows:
Opportunity Cost = FO – CO.
Calculating opportunity cost is simply comparing the expected return of your alternatives.
Let’s say you have an option to invest $5,000 in the bond market with an expected return of 5% per annum. Meanwhile, you have a second option to invest the same money in the stock market which, although it has a higher risk, promises a return of 10% per annum. However, you feel that bonds present a lower risk, so you decide to invest your money there for the next year. In this case, the opportunity cost will be:
Opportunity cost = 10% – 5%
Opportunity cost = 5%
In simple terms, by investing in bonds instead of the stock market, you will forgo the opportunity to earn a higher return on your money.
Opportunity cost inherently drives investment decisions. You’ll incur the wrong opportunity costs when you choose the wrong investment option. You can mitigate the uncertainty of returns by constructing your portfolio strategically and determining the percentage to comfortably allocate to each asset.