When it comes to making investment decisions, it is important to compare different options to find the one that best suits your needs. While there are various ways to evaluate your investment choices, opportunity cost is one of the most widely used concepts you can consider. This analysis helps you weed out options that will not help you reach your goals. It can offer you more clarity in your decisions and ensure your choices are aligned with your financial needs.
A financial advisor can help you understand the opportunity costs of choosing one investment over another. This article will also dive into this concept in detail so you can apply it to make smarter investment choices.
What is the opportunity cost of an investment?
Opportunity cost is a concept that plays a crucial role in multiple areas of life, including investing. It represents the potential benefits that are lost when choosing one option over another. Austrian economist Friedrich Von Wieser introduced the term in the late 19th century, and it remains a fundamental principle that is used widely even today.
The concept of opportunity cost is based on the fact that every decision you make involves a trade-off. For instance, when you decide to invest in one asset, you are automatically giving up the opportunity to invest in another that could have provided a different return. This is also known as a missed opportunity. While the outcome of any investment choice is uncertain, opportunity cost can help you weigh potential gains against losses from multiple investments to make informed decisions.
One way to express opportunity cost is through the following formula:
Opportunity Cost = RMPIC − RICP
Where:
RMPIC = Return on the best investment option
RICP = Return on the investment you choose to pursue
This formula can help you compare different investment choices and understand what you essentially let go of in terms of potential return. For example, consider a scenario where you have the option to invest in Stock A, which has a projected return of 10% per year or Stock B, with an expected return of 7% per year. If you choose Stock B, you give up a potential 3% return that you could have earned from Stock A. This 3% difference between returns is the opportunity cost of choosing Stock B over Stock A.
Since there is no way to guarantee that the projected returns from either investment will actually materialize the way you expect them to, opportunity cost is not a foolproof measure. In fact, the investment that looked less profitable at the time of decision-making may end up outperforming the one that initially seemed like the better choice. Nevertheless, understanding opportunity cost can help you compare multiple options at the moment of decision-making. It can help you select the suitable option when faced with more than one choice. Even if the final outcome does not align with your expectations, opportunity cost can help you make more informed investment decisions.
How do you determine the opportunity cost of an investment?
Opportunity cost represents the benefits that you have to forgo when choosing one investment over another. Every investment carries its own level of risk and potential return, which is why understanding how to employ the concept of opportunity cost is essential. Let’s consider an example of how you can determine the opportunity cost of an investment when you have to choose between two options:
A stock with an expected 12% annual return
A Certificate of Deposit (CD) with a guaranteed 4% return
If you invest in the stock, your opportunity cost is the 4% safe return from the CD. On the other hand, if you choose the CD, you miss out on the stock’s potential 12% return. However, you also have to note that the stock not only offers a high return but also comes with higher risk. Its value can fluctuate a lot more than the CD, and there is no guarantee that you will actually earn the 12% return. In some cases, you may incur losses. Moreover, the stock investment can also bring in stress and anxiety, as it is more prone to fluctuations. The CD, while offering a lower return, can give you financial stability and peace of mind. It is also suitable for short-term goals, as it can be redeemed in a relatively shorter span of time. If you plan the same with a stock, you might incur losses as stocks generally take longer to stabilize and provide high returns. Hence, in this case, your decision comes down to your individual risk tolerance and investment horizon. If you need access to your money soon and are looking for a stable choice, the CD might be the smarter choice. But if you are investing for the long term, you might be willing to take on more risk and can invest in stocks.
Here’s another real-world scenario to better understand how to figure out opportunity cost. Imagine you have $12,000 to invest and are considering three options:
Real Estate Investment Trust (REIT): Averages a 11.3% annual return but comes with higher risk.
Municipal bond: Provides a 4% annual return, is lower-risk, and may offer tax benefits.
Savings account: Gives a 1% annual return but keeps your funds safe and accessible.
Let’s analyze each choice by employing the formula to calculate opportunity cost:
Opportunity Cost = RMPIC – RICP
Choosing the REIT (11.3% return)
The municipal bond with a 4% return is the best alternative here because it offers the highest return among the remaining choices while also being a lower-risk investment.
Opportunity cost = 4% – 11.3% = -7.3%
Investing $12,000 in a REIT at a return of 11.3% generates $1,356, while a municipal bond with the same investment at a 4% return yields $480. The opportunity cost of choosing the REIT over the municipal bond will be:
$480 – $1,356 = -$876.
This negative opportunity cost indicates that the REIT offers a significantly higher return. However, opting for the REIT will result in letting go of the stability and tax benefits associated with municipal bonds.
Choosing the municipal bond (4% return)
The REIT (11.3%) is the best alternative because it offers a significantly higher potential return, even though it comes with more risk. The opportunity cost of choosing a municipal bond over a REIT is 7.3% (11.3% – 4%). The REIT generates earnings of $1,356, while the municipal bond yields $480. This results in an opportunity cost of:
$1,356 – $480 = $876.
If you opt for municipal bonds, you will be exposed to lower risk and benefit from potential tax advantages, but you will also have to forgo $876 in potential gains that could have been earned with the REIT.
Choosing the savings account (1% return)
With a return of 11.3%, the REIT is the best alternative as it provides the highest earnings, albeit with greater risk. The opportunity cost of choosing a savings account over a REIT is 10.3% (11.3% – 1%). The REIT generates $1,356 in earnings, while a savings account earning 1% yields just $120. This results in an opportunity cost of:
$1,356 – $120 = $1,236. While a savings account offers safety and liquidity, it comes at the expense of $1,236 in potential earnings that could have been gained through the REIT.
What is the biggest factor in opportunity cost?
Multiple factors in opportunity cost can impact your decision-making. Evidently, returns are the primary factor when ascertaining the opportunity cost of investments. However, factors, such as time, risk, scarcity, and personal bias also play a crucial role.
Some investments require years to grow, while others provide quicker returns. If you lock your money into a long-term investment, you miss the chance to take advantage of short-term opportunities. Additionally, some investments may require more time and effort than others. For example, active stock trading demands constant market monitoring and research. If you opt for a passive approach, you do not need to spend as much time monitoring your investments. Index funds are a great example of hands-off investing, where you can adopt a passive strategy and leave it up to the fund to mimic the benchmark it follows.
Let’s consider two investment choices to understand this better:
Stock A requires frequent monitoring and adjustments but has the potential to earn 14% annually.
Stock B requires no active management and has an expected return of 9% annually.
If you choose Stock A, you need to factor in the additional time spent managing your investment portfolio. That time could have been used to pursue other income-generating activities, such as freelancing to earn extra income, working overtime at your present job, or looking for more profitable assets, such as real estate. If Stock B provides a reasonable return with minimal effort, you must decide whether the extra 5% return is worth the additional time commitment. In many cases, passive investing allows you to maximize your overall financial well-being by freeing up time for other productive ventures. However, there is no guarantee that you will use this freed-up time to make more money. You might choose to spend it on personal endeavors or family time. In that case, while the opportunity cost of choosing Stock A may seem better in purely financial terms, Stock B could still be the smarter choice if it enhances other areas of your life.
Additionally, every financial choice carries some level of risk. If you choose a stable, low-risk investment, you have the potential for higher returns. On the other hand, while this might lead to bigger rewards, it also presents a chance of loss. For example, keeping money in a savings account instead of investing in REITs might feel safe, but it also poses a threat to your long-term goals. Emotional biases also impact opportunity costs. Preferring familiar investments due to personal affiliations or past experiences is common among investors. For example, you may want to invest in a sector where you previously earned profits or avoid some that were affected after a market crash. Scarcity is another factor that influences the opportunity cost of investments. If your capital is limited, you may prefer investments that offer guaranteed returns to ensure you do not lose your money. Contrarily, you may be tempted to explore more high-risk options with the motivation to grow this limited capital into substantial wealth. Each decision comes with a trade-off. Scarcity may also apply to time, skills, and energy.
What are the pros and cons of using the concept of opportunity cost for investments?
Opportunity cost comes with both advantages and limitations. It helps you compare options with a structured approach, making it easier to make well-informed financial choices. Opportunity cost can simplify the selection process, especially if you are struggling to decide between multiple investments. The analysis also helps ensure that the investment you choose matches your personal goals, time horizon, and risk tolerance. Additionally, it helps you allocate your limited capital in a way that maximizes potential returns while keeping risks in check.
However, it is not a failsafe strategy. No one can predict the future with certainty. The investment that looks best today might not perform as expected due to market fluctuations, inflation, or political and economic changes. Since opportunity cost is based on estimates, it is not always 100% reliable. Moreover, your past experiences and personal preferences can shape how you view opportunity cost, which makes the analysis more subjective than objective.
To conclude
Opportunity cost may not be a guaranteed method for finding the perfect investment for your financial needs, but it gives you a starting point. It encourages you to analyze and compare your investment options and helps you make more informed decisions. Understanding what you are potentially giving up allows you to set realistic expectations and prepare for varying future outcomes. Most importantly, it provides you with peace of mind.
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