Opportunities costs are the way to compare one choice in economics versus the most suitable alternative. These types of comparisons are often encountered in economics and finance when deciding between various investment alternatives. The opportunity cost seeks to quantify the effects of making a decision on one investment over one.
Here’s the method to calculate the opportunity cost and some of the ways to use it to guide your investment decisions, and much more.
What Is Opportunity Cost?
Investors are constantly confronted with the decision of how best to put their cash in order to earn the most lucrative or secure return. The opportunity cost of an investor is the cost of an unaffordable alternative. If you select one option over the other and the price of choosing that option becomes your opportunity cost.
A straightforward way to think of the opportunity cost as trade-offs. There is a trade-off in every decision that requires renunciation of one option in exchange for an alternative. For instance, if you decide to invest in bonds issued by the government instead of high-risk stocks, you’ll face an opportunity cost in the choice you made. The opportunity cost attempt to give a particular value to the trade-off.
How Do You Calculate Opportunity Cost?
A person who invests calculates the cost of opportunity by comparing the return of two alternatives. This is done during the decision-making process, by making estimates of the potential return. Or, the opportunity cost can be calculated with the benefit of hindsight by comparing returns from when the decision was taken.
The formula below illustrates the opportunity cost calculation to help an investor compare the returns of various investments:
How Opportunity Cost Works
Investors attempt to think about the potential risk of opportunity when making decisions, however, the calculation of the opportunity cost is much more precise using the benefit of retrospective analysis. If you have actual numbers to use rather than guesswork it’s much easier to compare the performance of an investment you’ve chosen to an alternative you’d rather not take.
As an example, suppose your aunt was forced to choose between purchasing shares from Company ABC and Company XYZ. She picks ABC. One year later, ABC has returned 3 percent, whereas XYZ has yielded 8 percent. In this instance, the investor can easily calculate her opportunity cost at 5 percent (8 percent plus 33 percent).
Opportunity cost is frequently utilized by investors to evaluate investment options, however, the idea is applicable to many different situations. If your friend decides to leave work for the entire year to attend school, for instance, the opportunity cost of that decision is the number of wages lost. The friend will evaluate the potential cost of lost earnings with the benefits of obtaining a higher education degree.
It is also worth considering the cost of opportunity when you are deciding on what you will do with your time. For instance, suppose that Larry is an attorney who costs $400 an hour. He decides to shut down his office for the day to paint office himself, believing that it will save money by not hiring professional artists. But the painting took four hours, which cost the company $1,600 in wages lost. If professional artists would charge Larry $1000 for his task. The opportunity cost for Larry was $600 ($1,600 $1,600 – $1,000).
Limitations of Opportunity Cost
The most significant drawback of the chance cost is that it’s difficult to accurately predict the future return. It is possible to study previous data to gain an idea of how your investment will do however you are unable to forecast the performance of an investment with 100 percent certainty.
The thought of the cost of opportunity is an essential element of making a decision however, it’s not reliable until the decision is made and you are able to see how the two investment choices have performed.
The concept of opportunity cost is applicable to all decisions however, it is difficult to quantify when you think about things that cannot be quantified with an amount in dollars. If you’re faced with two investment options. One is a safe return but requires the tying of your money to two years and the other one won’t permit you to move your money for 10 years. However, it’ll pay more rates of interest but carry a higher risk. In this instance, a portion of the risk will be the difference in liquidity.
The largest chance cost with regard to liquidity is the possibility that you be missing out on an excellent potential investment in the near future due to the fact that you’re unable to gain access to the money you’ve invested in a different investment. It’s an actual opportunity cost however it’s difficult to quantify using the dollar value, and therefore it’s not easily incorporated into the equation of opportunity cost.
