Before learning to make good investment decisions, it’s a good idea to learn the answer to the question, “what is opportunity cost?”
The opportunity cost of an investment refers to the potential gain or loss incurred by not choosing to go with a different investment.
Investors at all income levels have a limited amount of funds to work with. And while some people are more risk-tolerant than others, considering the opportunity cost of choosing one investment over another will always be necessary. Otherwise, an investor will be more likely to either take excessive risks or miss out on good returns.
The concept of opportunity cost can be applied to almost any situation—not just financial matters. But, we are concerned with the definition of opportunity cost when it comes to investments.
For this kind of opportunity cost, it’s especially important to consider the risks involved. Failing to do so can lead investors to make less than optimal decisions.
Opportunity Cost vs. Risk
When thinking about the question “what is opportunity cost?”when it comes to investments, risk is an essential factor to include in any consideration.
Failing to consider the potential risks of an investment when trying to calculate opportunity cost could lead to an “apples vs. oranges” type of comparison, that would then lead to inaccurate calculations.
Consider the following opportunity cost example.
Let’s say someone wants to figure out the opportunity cost of investing in a penny stock rather than buying a US Treasury bond. The latter are virtually risk-free, being 100% backed by the US government.
Penny stocks, on the other hand, carry a high amount of risk, being volatile and having a real possibility of going to zero if the underlying company goes bankrupt.
If an investor thinks about opportunity cost in this example without factoring in risk, he or she will choose the penny stock every single time. And without considering the risks involved, doing so would make sense.
Safer investments like US Treasury bonds tend to come with low returns. But the risk is virtually non-existent, making the low returns a sure thing. While a risky investment like a penny stock might yield big gains, it comes with significant risk, and could also yield large losses.
Investing in the penny stock risks losing capital, while investing in Treasuries risks losing the larger gains. Investors must weigh the pros and cons of decisions like this in order to be as successful as possible.
What is Opportunity Cost When Evaluating Investments?
There are two main types of opportunity cost as it relates to financial decisions.
The first type, explicit opportunity cost, is easy to calculate because it involves the objective value that an investor sacrifices when making one investment decision instead of another.
The second type of opportunity cost is the implicit opportunity cost. This one can be harder to calculate because it’s more subjective.
Implicit opportunity costs tend to involve resources and a lost opportunity to generate additional income rather than a direct cost.
For example, say someone owns a second home in the Hampton Islands. This person loves vacationing in the Hamptons so much that they choose not to rent out the home, foregoing the significant revenue that doing so might bring in. That lost revenue represents the implicit opportunity cost of using the home as a luxurious vacation destination rather than a rental property.
How to Calculate Opportunity Cost
It’s important to remember that any attempt at this kind of calculation will be somewhat of an estimation because it’s impossible to predict with 100% certainty. But, for the purposes of trying to calculate opportunity cost, it becomes necessary to make some related assumptions as to risk and reward.
When a skilled financial analyst wants to determine how to calculate opportunity cost, they might use a complex mathematical formula called the Net Present Value (NPV) Formula. This formula can be calculated in a spreadsheet and includes specific business factors like free cash flow, interest rates, and the number of periods in the future in which free cash flow will happen.
For most individual investors, an all-out calculation using the NPV Formula might be going a little overboard. The effort required could be unnecessary, and investors may not always have access to the required information.
However, some simple arithmetic can often work, too. The only required knowledge for such a calculation will be what an investor sacrifices by making one decision rather than another.
A Simple Opportunity Cost Formula
An opportunity cost example equation would look like this:
Opportunity Cost = FO – CO
Where FO is equivalent to the return on the best foregone option, and CO is equivalent to the return on the chosen option. In other words, subtracting the amount of money made on a chosen investment from the amount of money that would have been made on the other, not chosen, investment.
Beyond that, it can also be worthwhile to take into consideration the variables of time and sweat equity.
Sweat equity refers to the work that might be required to maintain something. Likewise, time refers to the time a particular economic decision will require.
For example, investors who tend to be more self-directed and choose to do their own research will likely want to pick each specific security in their portfolios and how much capital they want to allocate to each position. That research requires sweat equity, but could lead to higher returns if done well. Other investors may choose a more passive investment style and either put all of their available capital in a single ETF or use a robo-advisor that chooses security allocations for them. This method minimizes sweat equity but could potentially see lower returns.
When it comes to the simple math, let’s say an investor really likes Taco Bell. She typically eats three Taco Bell meals each week, costing about $10 each, for a total of about $120 per month.
Our imaginary Taco Bell fan could decide to cook her own meals three nights a week, with an approximate cost of $60 per month. She then invests the extra $60 she has now saved.
The opportunity cost in this random example is missing out on the Taco Bell experience. The gain would be having a little extra cash to invest each month.
Learning Opportunity Cost First-Hand
One thing’s for sure—in the long run, the opportunity cost of choosing to stay out of the market tends to be high. Would-be investors might miss out on potential gains.
Without having money work for itself and earn interest, dividends, or capital gains, it’s very difficult to build long-term wealth.
For those who would like an easy way to get started, SoFi Invest® has all the right tools.
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