Make Money

What is Opportunity Cost? Let’s Take a Closer Look at What it Means for You

Life is a series of decisions that shape our future. Each decision we make comes with a reward & an opportunity cost - Let's Take a Closer Look
Pinterest LinkedIn Tumblr

Life is a series of decisions that shape our future. Each decision we make comes with a reward and an opportunity cost. The reward is the positive outcome we receive for making our decision. The opportunity cost is what we miss out on when making that decision; it’s as simple as that.

However, opportunity cost can take on different forms in our lives. While there’s an opportunity cost for every decision we make, the impact it makes might be more relevant in your life, depending on the importance and consequences of making that decision.

Opportunity Cost Definition

Now that you have a grasp of the basic understanding of opportunity cost, let’s unpack it in further detail. If you have two or more options available to you in a decision, the opportunity cost is the downside of not taking the other options.

When we make decisions, we tend to err toward the choice that offers the best outcome.

This strategy helps us mitigate the loss of opportunity involved with the decision we make. Almost every decision we make in life consists in assessing the risk versus the reward involved with our choice. Therefore, we have hardwiring that helps us make the right decision in most cases.

However, there are times when we deeply regret our decisions and spend time mulling over “what could have been.” It’s a futile exercise thinking about what you miss out on with your choices in life.

However, that doesn’t’ stop our imagination from running wild with thoughts of what we possibly missed out on with our choice.

The key to being okay with your decision, and limiting regret involved with bad decisions, is to take responsibility for your decision-making process. By remaining accountable for your actions, you know that the outcome went the way it was supposed to, and it couldn’t be any different.

By being comfortable with your decisions, you remove the uncertainty involved with opportunity cost.

Opportunity cost is the next best alternative foregone.
Opportunity cost is the next best alternative foregone. Source

The Limitations of Scarcity

Unfortunately, we live in a finite world. There are limitations on your money, time, and effort, all of which determine your outcome in life. These limitations on our resources cause us to act in the best way that ensures self-preservation. As a result, we end up weighing the opportunity cost of many of the decisions we take in life.

However, it’s important to note that the opportunity cost is directly scalable to the size of your decision. Each decision we make varies in the degree of importance and impact it has on our life. Some decisions are more critical than others, and that affects how we handle the opportunity cost involved with the situation.

For instance, you might wake up and not feel like eating. You now have a choice to make in your life. You can either eat or decide not to eat. The decision for both has a benefit and an opportunity cost.

If you decide not to eat and head out to work with an empty stomach, the opportunity cost is that you might feel hungry at work, and have low energy levels that affect your performance.

While this is an example of an easy life decision with a relatively low opportunity cost, it’s important to note that this scenario plays out with every decision we choose to make in our lives.

Other Examples of Opportunity Cost

When most of us think about opportunity costs, we imagine something simple in life. For example, you might settle down for an evening’s entertainment, presenting you with two options. You could either read a book or watch Netflix. If you decide on reading the book, then the content you’re missing on Netflix is the opportunity cost involved with your decision.

However, we make all types of decisions in our life, and some of them are more important than others. One of the best ways to get a handle on opportunity cost is to look at how it affects your investments.

Examples of Opportunity Cost with Investing

There are decisions in life that aren’t always as simple as deciding on Netflix or a book for entertainment. Choosing the right investments for your financial needs is an excellent example of where opportunity cost has an impact on your finances, exacerbating the importance of making the right choice.

A great example of the opportunity cost for investors exists in the stock market. At the end of the last financial meltdown in 2008, many investors decided to turn away from the stock market and move their assets into cash.

Over the last decade or so, the S&P500 index rose from a low of 666 in 2008 to all-time highs of 3,200. If you’re an investor sitting on the sidelines in cash, expecting a crash, then the opportunity cost involved with your decision takes on a monetary amount.

It seems like we always fret more about opportunity costs when it includes money in the equation.

Best Investment Ideas for Millennials
Best Investment Ideas for Millennials: Complete Guide

How Can You Take Advantage of Opportunity Cost Investing?

So, you just got your Christmas bonus, and you’re wondering whether you should put the extra money you have into Tesla or Facebook stock. One of the critical considerations for determining your decision is the opportunity cost involved with choosing one stock over the other.

If you put your money into Tesla, and the stock tanks, the opportunity cost involved is the money that you would have made if you decided to invest in Facebook instead. It’s possible to allocate a number to that opportunity cost.

It’s also important to note that the opportunity cost6 in this example might also come with a time-frame attached. For example, if you do take the Tesla shares with your bonus, you probably have an investment horizon in mind where you liquidate the stock and turn it into cash to fund your retirement.

Let’s say you want to keep your Tesla stock for 6-months. During those six months, the Facebook stock rises by $10,000, but your Tesla Stock only increases by $5,000. Your immediate opportunity cost is the extra $5,000 you could have made by investing your money with Facebook.

However, if the Facebook stock rises by $10,000 in half the time it takes your Tesla Stock to reach $5,000, there’s also an opportunity cost involved as well. In this case, you could have made the same amount of money with Facebook as you did with Tesla, in half the time. Therefore, the deal has an opportunity cost of 3-months as well.

In the world of investment, time is money. Three months’ worth of your investment career can add up to plenty of profits over that period that you’re missing out on with your decision to go with Tesla over Facebook.

Unfortunately, when you do make your investment decision, the outcome is almost always uncertain. Therefore, beating yourself up about the opportunity cost in the deal is not worth the mental anguish involved.

How to Start Investing
How to Start Investing (Even With Small Amounts): Complete Guide

Considerations for Opportunity Costs

Let’s look at another example of opportunity cost when it comes to investing. If you have the choice between two investments, you need to weigh the opportunity costs of both. With one investment, you need to tie up your capital for 2-years, while with another investment, you might have to park your money for 5-years.

The opportunity cost in the deal is losing liquidity for the additional three-year period involved with the 5-year contract. Maybe you come across a new deal in 4-years that’s better, and you can’t gain access to your capital without taking a stiff penalty from the financial services provider or broker.

You might also encounter a medical emergency that requires you to take a loan for treatment. In this case, the opportunity cost would be the interest you have to pay. When considering the opportunity cost involved with your financial decisions, you need to take all of these factors into account.

Explicit and Implicit Costs

When looking at the opportunity cost in a deal, we have to analyze two factors, the implicit and explicit costs. Let’s take the example of going to college.

The explicit costs involved with going to college include things like your books, tuition fees, housing, and food. Essentially, they’re costs that require you to make a physical payment.

The time it takes you to earn your degree is an implicit cost. These types of expenses don’t come with a price tag attached, and it’s challenging to calculate the monetary value of these actions.

Another implicit cost involved with your decision to attend college is the money you’re losing out from if you decide to go and join the workforce instead. When making decisions, most people will focus on the explicit costs over the implicit opportunity costs involved with their decision-making process. Unfortunately, this is not always the correct way to look at things.

If we take the example of a professional training course, then the explicit costs involved with taking the class might outweigh the benefits involved with learning the course material. However, the converse is also true. If you decide to spend the extra $1,000 on the course, it might lead to an increase in your salary.

In both cases, there are opportunity costs. You might think that the cost of the course means that you can’t buy a new TV at the end of the month. The immediate opportunity cost is that you have to deal with your old TV. However, if you do decide to take the TV over the course, then the opportunity cost is the additional money you could make on your annual salary if you upgrade your skillset.

In this case, the opportunity cost involved with not taking the course far outweighs the opportunity cost of missing out on the new TV. Thus, your decision should shape itself around the choice that allows you to prosper in the future, not the choice that brings you immediate gratification.

The Opportunity Cost of Doing Nothing

While most of us equate opportunity cost to taking action, taking no action is also a choice. Inaction on your decision-making process also has an opportunity cost included as well. Time is not only vital to your investments, but it also has a valuable role in your life as well.

Let’s say your lining up a job that could be your dream vocation. However, the position is only available in 6-months’ time when the current person leaves. Your currently unemployed, and you get another offer for a job that pays the same amount, but it’s not the position you want in your career.

The immediate opportunity cost is losing the 6-months of salary you could earn by not accepting the next position. There’s also an opportunity cost involved with sitting around on your hands for 6-months while you wait for the job opening to materialize.

Now let’s say you wait for the 6-months, and the job falls through. You deal with the opportunity cost of time and money, as well as the potential damage to your career. Inaction can have a few benefits, but most of the time, it’s going to cost you.

With investments, doing nothing can pay off sometimes. You might find yourself frozen in your investment decision to sell or hold a stock. During the time you wait, the shares might increase in value, reducing your opportunity cost. However, it might tank as well, increasing your opportunity cost.

Wrapping Up – Make Better Decisions

One way to reduce your opportunity cost is to improve your decision-making process. Every decision we make has consequences, and they are not always good. By taking the time to analyze your investment decisions before you take action, you’ll improve your results and reduce opportunity costs.

Don’t rush into any decisions, and always take advice from people you trust when it comes to investment decisions. Use a mentor or a financial advisor as a sounding board when making your choice, and listen to your intuition as well.

Carefully weigh out your options and then make your decision based on the opportunity cost involved with the deal. Remember to think about the long-term implications of your choice, rather than focusing only on the short-term.

Further Reading

Avatar

Oliver Dale is Editor-in-Chief of MoneyCheck and founder of Kooc Media Ltd, A UK-Based Online Publishing company. A Technology Entrepreneur with over 15 years of professional experience in Investing and UK Business.His writing has been quoted by Nasdaq, Dow Jones, Investopedia, The New Yorker, Forbes, Techcrunch & More.He built Money Check to bring the highest level of education about personal finance to the general public with clear and unbiased reporting.oliver@moneycheck.com

Write A Comment