Opportunity Costs

In an ideal world, everybody would have whatever they wanted, but this isn’t always the case. Tradeoffs are often required, which means settling for alternatives, but what is the cost of that tradeoff? Opportunity costs-the value of the best alternative option not chosen-help calculate the cost of alternative options. It’s a concept often used by economists, investors or businesses but can be adapted in many other ways. Whether we realize it or not, we use some level of opportunity cost every day when deciding between two job opportunities, multiple investments, or places to live.

Opportunity cost is important because it can impact profitability. It gives insight to the cost of each choice one is weighing and is a reminder that every choice results in losses and gains.

Examples of Opportunity Costs

Any decision being contemplated has an opportunity cost. There is always a chance that the other option could end up being more lucrative than the one you end up choosing.

Let’s say a real estate business is making a decision about whether to acquire two new properties. The opportunity cost of not buying them would be the tentative profit the business would lose by not acquiring the new properties.

A real-life example is if a consumer wanted to buy a car worth $20,000. It would be financially beneficial to explore the opportunity costs of other alternatives and see if they could get a car with better features for $20,000 or something of similar value for cheaper.

The ultimate goal of opportunity cost is to gain clarity about what you’re giving up to get what you’re choosing. You’d then ideally choose the option that’s worthwhile irrespective of what you’ll lose.

Calculating Opportunity Cost

There is an equation people can use to calculate opportunity costs:
Opportunity cost + FO – CO

FO = Return on the best option forfeited
CO = Return on the chosen option

For example, if you’re choosing between a stock with an expected return of 10% and a rental property with an expected return of 7%, the opportunity cost of choosing the latter is 3%. For the most part, the greater the risk of losing money on the option you don’t choose, the better the returns on the option you do choose.

Opportunity Costs in Investing

In the context of investing, opportunity costs can help decide whether an investor should choose one option over another. This could include deciding whether to invest in a stock instead of a bond or buy 100 shares of one stock versus 100 of another. A factor you may use to make your decision include the annual return of each investment.

In another example, let’s say an investor only has $1,000 to invest and has to choose between investing in a relatively new company growing exponentially or spread that cash between multiple established companies. The opportunity cost would be the potential returns they would lose by choosing one option over another.

When comparing two choices and trying to figure out opportunity costs, it may be easier to compare similar investments. For instance, comparing an individual stock that’s high risk to a bond that’s a relatively safe investment may not give you a clear picture of the opportunity cost.

That said, with investing you can never predict the market, so opportunity costs can only be used as a guide. A financial advisor can help you weigh the costs of different investment choices. Reach out to us today dn someone from our team can help.