Opportunity cost is the comparison of one economic choice to the next best choice. These comparisons often arise in finance and economics when trying to decide between investment options. The opportunity cost attempts to quantify the impact of choosing one investment over another.
Here is the way to calculate opportunity cost, along with some ways it can be used to inform your investment decisions and more.
What Is Opportunity Cost?
Investors are always faced with options about how 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.
Opportunity costs are a factor not only in decisions made by consumers but by many businesses, as well. Businesses will consider opportunity cost as they make decisions about production, time management, and capital allocation.
A simple way to view opportunity costs is as a trade-off. Trade-offs take place in any decision that requires forgoing one option for another. So, if you chose to invest in government bonds over high-risk stocks, there's a trade-off in the decision that you chose. Opportunity cost attempts to assign a specific figure to that trade-off.
How Do You Calculate Opportunity Cost?
An investor calculates the opportunity cost by comparing the returns of two options. This can be done during the decision-making process by estimating future returns. Alternatively, the opportunity cost can be calculated with hindsight by comparing returns since the decision was made.
The following formula illustrates an opportunity cost calculation, for an investor comparing the returns on different investments:
How Opportunity Cost Works
Investors try to consider the potential opportunity cost while making choices, but the calculation of opportunity cost is much more accurate with the benefit of hindsight. When you have real numbers to work with, rather than estimates, it's easier to compare the return of a chosen investment to the forgone alternative.
For example, imagine your aunt had to decide between buying stock in Company ABC and Company XYZ. She chooses to buy ABC. A year later, ABC has returned 3%, while XYZ has returned 8%. In this case, she can clearly measure her opportunity cost as 5% (8% - 3%).
Opportunity cost is often used by investors to compare investments, but the concept can be applied to many different scenarios. If your friend chooses to quit work for a whole year to go back to school, for example, the opportunity cost of this decision is the year’s worth of lost wages. Your friend will compare the opportunity cost of lost wages with the benefits of receiving a higher education degree.
You can also consider the opportunity costs when deciding how to spend your time. Say that Larry, an attorney, charges $400 per hour. He decides to close his office one afternoon to paint the office himself, thinking that he's saving money on the costs of hiring professional painters. However, the painting took him four hours, effectively costing him $1,600 in lost wages. Let's say professional painters would have charged Larry $1,000 for the work. That means Larry's opportunity cost was $600 ($1,600 - $1,000).
You chose to read this article instead of reading another article, checking your Facebook page, or watching television. This choice resulted in a trade-off. Your life is the result of your past decisions, and that, essentially, is the definition of opportunity cost.
Limitations of Opportunity Cost
The primary limitation of opportunity cost is that it is difficult to accurately estimate future returns. You can study historical data to give yourself a better idea of how an investment will perform, but you can never predict an investment's performance with 100% accuracy.
The consideration of opportunity cost remains an important aspect of decision making, but it isn't accurate until the choice has been made and you can look back to compare how the two investments performed.
While the concept of opportunity cost applies to any decision, it becomes harder to quantify as you consider factors that can't be assigned a dollar amount. 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 it will pay higher interest with slightly more risk. In this case, part of the opportunity cost will include the differences in liquidity.
The biggest opportunity cost regarding liquidity has to do with the chance that you could miss out on a prime investment opportunity in the future because you can't get your hands on your money that's tied up in another investment. That's a real opportunity cost, but it's hard to quantify with a dollar figure, so it doesn't fit cleanly into the opportunity cost equation.
- Opportunity cost measures the impact of making one economic choice instead of another.
- While it's often used by investors, opportunity cost can apply to any decision-making process.
- Opportunity cost can be considered while making decisions, but it's most accurate when comparing decisions that have already been made.