Opportunity cost refers to the value you lose out on when you choose one opportunity over another. It could apply to every facet of your life, from the income opportunities you lose out on by choosing one job over another to the way you choose to spend your time.
But it’s especially important when it comes to investing, where opportunity cost refers to the potential returns you miss out on by choosing one investment over another. The truth is there’s always something else we could have chosen to do with our money that could have provided a financial return. Luckily there’s a way to calculate opportunity cost to ensure you’re making the right decisions.
Example of an Opportunity Cost
Examples of opportunity costs are all around us. They’re prevalent in our careers and the business opportunities we choose to go after. For example, when you accept a job offer, you have an opportunity cost that’s the higher income you could have earned elsewhere.
Opportunity cost also plays an important role in the way we spend our time. We each have a finite amount of time. If you have two hours of free time every evening, there are only so many ways you can use it. You could spend that time watching Netflix but would have the opportunity cost of the value you would have gotten from spending time with your family instead.
Other real-world examples of opportunity cost include:
- The time you lose taking the bus to work instead of driving as a way to save money
- The investment returns you could have gotten from the money you instead spent on your college education
- The money you could have saved by renting an apartment in a less desirable part of town
How to Calculate Opportunity Cost
When calculating opportunity cost, what you’re really doing is calculating the difference between the return on the forgone option and the return on the option you chose. Remember, opportunity cost isn’t simply the return you could have gained from choosing a different option. It’s simply the return you could have gained above and beyond the return from the opportunity you chose.
To calculate opportunity cost, you can use the following formula:
Opportunity Cost = Return on Forgone Option – Return on Chosen Option
For example, let’s say you have the opportunity to put $1,000 into your brother’s business for a return of 10%. But instead, you could put that money into an S&P 500 index fund. To determine the opportunity cost of investing in your brother’s business, you would subtract the return of the business opportunity from the potential return of the S&P 500 index fund.
If the opportunity cost is positive, it means you would have earned a higher return investing in the forgone option. But if the opportunity cost is negative, it means you made the right choice by investing in your brother’s business.
Of course, potential returns aren’t the only thing to consider when making an investment opportunity — especially short-term returns. The S&P 500 index fund may provide a higher return in a single year. But investing in your brother’s business could provide increasingly higher returns each year.
Opportunity cost also doesn’t take into account other factors, such as risk. We’ll discuss later how risk plays a role in opportunity cost and choosing investing opportunities.
Opportunity Cost in Investing
As we’ve discussed, opportunity cost is especially important as it relates to investing. At the end of the day, you only have so much money to invest. And choosing one investment opportunity always means you’re forgoing many other opportunities.
If you have $1,000 to invest, there are only so many ways you can invest it. Sure, you could buy cryptocurrency in the hopes of earning a huge profit. But you could end up with an opportunity cost from the money you could have made by investing in a stock or exchange-traded fund (ETF).
One of the best ways to overcome this opportunity cost is to create a well-diversified portfolio. You aren’t investing in a single stock and then being stuck with the opportunity cost of the returns you could have made on other investments. Instead, you’re investing in many stocks and bonds — or better yet, mutual funds or ETFs — as a way to gain exposure to hundreds or thousands of assets in your portfolio.
No matter where you choose to invest or how diversified your portfolio is, you’ll still have some opportunity costs. But you reduce the overall risk of your portfolio and, therefore, reduce the risk of investment returns that are below the market average.
Opportunity Cost and Risk
As we mentioned, an important piece of information missing from opportunity cost is risk. Generally speaking, the higher the investment risk, the higher the potential returns.
Previously we talked about an example of choosing to invest in either your brother’s business or an S&P 500 index fund. If your brother’s business had a higher potential return, the opportunity cost formula might tell you that was the better option.
But what the calculation doesn’t compare is risk. Investing in a diversified market fund could be lower risk than investing in a new business. Your potential returns may be slightly lower, but your chances of actually achieving those returns is higher.
When making investment decisions, it’s quite common to accept some opportunity cost for the benefit of a lower-risk investment. It’s why many people invest in diversified mutual funds and ETFs rather than individual stocks, hedge funds, or venture capital.
Opportunity Cost vs. Sunk Cost
Opportunity cost and sunk cost are two potential costs you’re likely to run into in the world of business and investing.
A sunk cost is money you’ve already spent and can’t recover. For example, if you invest $1,000 in a business, you would consider it a sunk cost. Regardless of whether the investment provides a return, you’ve already put your $1,000 in. While the $1,000 investment represents your sunk cost, your opportunity cost for the same investment is the amount you could have earned by investing that same money elsewhere.
As investors — and even as consumers — many of us fall for what’s known as the sunk cost fallacy. Even when an investment is performing poorly, we tell ourselves we can’t back out because we’ve already spent so much money on it.
Suppose you’ve invested $1,000 in a new business. The business is clearly failing, meaning your chances of getting your $1,000 back are slim. Under the sunk cost fallacy, you might convince yourself that because you’ve already invested this much, you should invest even more in the company in the hopes of turning it around. In other words, you’re throwing good money after bad.
And just like opportunity cost, sunk cost can also play a role in your everyday life. Suppose you bought a new book that you’ve heard great things about. You spent $25 on the book, but by the time you’re a quarter of the way through it, you hate it. Under the sunk cost fallacy, you would convince yourself that because you’d already invested time and money into the book, you should finish it. But that time and money are gone either way.
Next Steps for You
Opportunity costs present themselves in every area of your life, whether it’s your career or your investment portfolio or your personal life. As a result, it’s important to understand how it works and be able to look objectively at the opportunity costs you sacrifice when you make certain decisions.
Of course, opportunity cost isn’t the only thing that comes into play with investing. And having the right tools by your side can make it easier to manage your personal finances and make investment decisions. Personal Capital’s free financial dashboard has all of the tools you need to plan your next financial steps, from a budgeting tool to a savings planner to an investment checkup tool. Sign up for free today.
Author is not a client of Personal Capital Advisors Corporation and is compensated as a freelance writer.
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