Definitions and Examples of Opportunity Cost

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Investors are always faced with options about where they should invest their money.

Opportunity cost is the cost of a foregone alternative. If you chose one alternative over another, then the cost of choosing that alternative is an opportunity cost.

The term opportunity cost is often used in finance and economics when trying to choose one investment, either financial or capital, over another. It is a measure of any economic choice as compared to the next best one.

For example, there is an opportunity cost over choosing an investment in bonds over an investment in stocks.

Why Opportunity Costs Matter

Opportunity costs are a factor not only in decisions made by consumers, but in other decisions as well such as production, time management and capital allocation.

Alternative Financial Actions

When referring to opportunity costs, investors often see it as the benefits you would have received by taking an alternative financial action.

The difference in return between a chosen investment and one that is the forgone alternative is essentially your opportunity cost. For example, if you invest in a stock and it returns only 3% over the year, and you gave up the opportunity of another investment yielding 8%, your opportunity costs are 8% - 3%, which is 5%.

For example, there is an opportunity cost over choosing an investment in bonds over an investment in stocks.

Opportunity Cost Viewed as a Trade-Off

Some investors view opportunity costs as a trade-off. So if you chose to invest in government bonds over high-risk stocks, that's a trade-off on return that you chose.

Trade-offs are when you forgo one options for another. There are trade-offs involved in any decision that requires choosing one option or another. For example, if you chose not to go to one restaurant in order to eat at another, that is a trade-off.

You chose to read this article instead of reading another, checking your Facebook page or watching television. You made a choice that resulted in a trade-off. Your life is the result of your past decisions.  That, essentially, is the definition of opportunity cost.

What is Liquidity of Opportunity Cost?

If two investments have the potential to generate the same return, but one requires you to tie up your cash for two years, while another won't allow you to touch your money for 10 years, you need to make a decision based on how liquid you need your money to be.

One option may be more attractive based on the predicted rate of return, but the other option may be more appealing based on the need for your money to be liquid.

The biggest opportunity cost when it comes to liquidity has to do with the chance that you might pass up a "hot"  investment because you can't get your hands on your money that is tied up in another investment.

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