Opportunity cost quantifies the potential benefits that are lost when one alternative is chosen over another. Whether you’re an individual deciding whether to invest in bonds over stocks or a business leader strategizing for growth, the principles of opportunity cost can help you make more informed investment choices. A financial advisor can also help you compare different investment options and select the ones that best align with your goals and needs.
What Is Opportunity Cost?
Opportunity cost, a pivotal concept in economics, investing and personal finance, encapsulates the potential benefits lost when one alternative is selected over another.
The term was first coined by Austrian economist Friedrich von Wieser in the late 19th Century, and it has since become a cornerstone of economic theory. By quantifying what is sacrificed when a particular path is pursued, opportunity cost serves as a critical tool for evaluating the relative worth of various choices.
For investors, opportunity cost refers to the potential returns they forego when they commit capital to one investment over another. Consider an investor who must choose between a low-risk government bond and a high-risk stock. By opting for the bond, they prioritize security over the possibility of higher returns. The opportunity cost here is the additional income that could have been earned with the more volatile equity option.
Similarly, businesses must consider opportunity cost when allocating resources to projects or initiatives. The funds dedicated to a new marketing campaign, for instance, are not available for product development or other potential investments.
How to Calculate Opportunity Cost
Understanding the importance of opportunity cost is the first step. The next is learning how to calculate it to make informed decisions. The formula to calculate opportunity cost is remarkably straightforward: it is the return of the option not taken minus the return of the option that is chosen.
The formula for opportunity cost is OC = FO – CO, where OC signifies opportunity cost, FO is the return on the foregone option and CO is the return on the chosen option.
By employing this calculation, you can concretely assess the benefits that might have been accrued had a different decision been made.
Examples of Opportunity Cost
For an investor, the concept of opportunity cost is particularly important to understand. When faced with multiple investment options, each with its own set of risks and rewards, the investor must consider what they are potentially giving up by choosing one investment over another.
Let’s take the example of an investor with $10,000 to invest who doesn’t need the money for at least five years. This investor is deciding between investing in an equity index fund that has historically returned an average of 8% per year or a low-risk government bond that pays out 5% per year.
The investor opts for the safer option and invests in the bonds. Over the next five years, the $10,000 investment grows to about $12,835. Had the investor put the money in the index fund, the investment would be worth approximately $14,900 at the end of the five-year period.
To calculate the opportunity cost of investing in the bonds, the investor simply has to subtract $2,835 from $4,900. The opportunity cost is $2,065.
Businesses also grapple with opportunity costs in their strategic planning and capital allocation decisions. A business with a finite amount of capital must carefully weigh the potential outcomes of each investment opportunity.
Let’s take as another example a company with $2 million to invest. This company is considering an expansion into a new geographic market, which could lead to an increased customer base and revenue. Alternatively, the company could also invest in research and development for a new product, aiming to strengthen its market position and attract new customers.
The opportunity cost of geographic expansion is the potential market share and competitive advantage that could have been gained from the new product.
Opportunity Cost vs. Sunk Cost
While opportunity cost focuses on the potential gains missed by opting for one choice over another, sunk cost refers to the resources that have already been spent and cannot be recouped.
For example, consider the Concorde jet project. Despite its iconic status, the Concorde became a prime example of the sunk cost fallacy in action. The British and French governments continued to fund the project for years despite its lack of economic viability. The substantial amounts already invested in its development made it difficult for the governments to discontinue funding, leading to continued investment in a project that was never profitable.
Understanding the clear distinction between these two principles is important for investors who are weighing investment options or evaluating the performance of current investments. Opportunity cost is forward-looking, considering the benefits of the next best alternative that is foregone when a decision is made. In contrast, sunk costs are retrospective and should not factor into current decisions.
Limitations of Opportunity Cost
One notable limitation of opportunity cost is the challenge of quantifying non-monetary factors. Qualitative aspects such as personal satisfaction, time or convenience are highly subjective and can vary greatly from one individual to another.
Moreover, the uncertainty of future outcomes complicates the accurate assessment of opportunity costs. Decisions can be based on predictions that may not materialize.
Additionally, cognitive biases can skew the perception of opportunity costs. An investor might fall prey to the sunk cost fallacy, continuing to invest in a declining asset because of the costs already incurred, rather than considering the benefits of alternative investments.
Bottom Line
Opportunity cost refers to the potential benefits or returns that are foregone when one choice is made over another. Understanding this can help you make more informed decisions, prioritize resources effectively and maximize the value of your choices by considering alternatives and their associated costs. Though it may also be difficult to quantify with accuracy and compare the value of those alternatives.
Tips for Investing
- Risk tolerance, or the amount of volatility an investor can tolerate, plays an important role in how lots of people invest their money. SmartAsset’s asset allocation calculator can provide recommendations for how much of your portfolio should be invested in stocks and bonds based on your risk tolerance.
- Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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