Definitions and Examples of Opportunity Cost
Investors are always faced with options about where to invest their money to receive the highest or safest return. The investor’s opportunity cost represents the cost of a foregone alternative. If you choose one alternative over another, then the cost of choosing that alternative becomes your opportunity cost.
If you choose not to go to work today, for example, your opportunity cost becomes your lost wages. If your friend John chooses to quit work for a whole year to go back to school, the opportunity cost of his decision is the year’s worth of lost wages.
The term "opportunity cost" comes up often in finance and economics when trying to choose one investment, either financial or capital, over another. It serves as a measure of an economic choice as compared to the next best one. For example, there is an opportunity cost of choosing to finance a company with debt over issuing stock.
Why Opportunity Costs Matter
Opportunity costs are a factor not only in decisions made by consumers but by many businesses as well, for areas such as production, time management, and capital allocation.
The following formula illustrates an opportunity cost calculation, for an investor comparing the returns on different investments:
Opportunity cost = Return on the best option not chosen - Return on the option chosen
Alternative Financial Actions
When referring to opportunity costs, investors often see it as the benefit you would have received by taking an alternative financial action. The difference in return between a chosen investment and your forgone alternative is essentially your opportunity cost.
For example, if your aunt Joan invested in ABC Company's stock and it returned only 3 percent over the year, and she gave up the opportunity of another investment yielding 8 percent, her opportunity costs become (8 percent - 3 percent) = 5 percent. She would also have an opportunity cost if she chose an investment in bonds over an investment in stocks.
It Pays to Calculate
Sometimes home or business owners fall into the trap of thinking that doing everything themselves will save them money. Say that Larry, an attorney, bills his clients at $400 per hour. He decides to repaint his office, but it takes him four hours, effectively costing him $1,600 in lost wages.
If he had done the simple math to figure this out, he could’ve hired painters who would’ve charged him only $1,000 for the same job. Larry’s opportunity cost is the difference, or $600.
Viewing 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 the return that you chose.
Trade-offs take place in any decision that requires forgoing one option for another. For example, if you chose not to go to one restaurant in order to eat at another, that is a trade-off.
On a large scale, when the U.S. government pays an interest bill on the national debt that equates to about $15 billion, it makes a trade-off of having less money to spend on programs like healthcare or education.
You chose to read this article instead of reading another article, 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, and that, essentially, is the definition of opportunity cost.
Choosing Between Differing Options
Sometimes decisions of opportunity involve more complexity than just comparing something like two different interest rates on investments. Say you have two investment opportunities; one offers a conservative return but only requires you to tie up your cash for two years, while the other won't allow you to touch your money for 10 years, but will pay higher interest with slightly more risk.
You need to make your opportunity-cost decision based on both your risk tolerance and on how liquid, or accessible, 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 regarding something like liquidity has to do with the chance that you could miss out on a prime investment opportunity because you can't get your hands on your money because it's tied up in another investment.