The last few years of instability in the market and economy at large may have you sitting out growth investing opportunities out of caution. However, historical guidance indicates the opportunity cost of waiting on the sidelines could make that a costly mistake.
Every opportunity you set aside or ignore brings a potential opportunity cost. When it comes to sitting out of investing in an uncertain market, that cost often proves a heavy one to bear.
Opportunity Cost Definition
Opportunity cost is a concept that describes the forgone returns of an opportunity you chose not to take. While it is a standard measure used by economists and finance professionals, it is also something you can use to inform your decisions in everyday life.
Whenever you have a choice between two options, opportunity cost is a measure of what you might miss out on by taking one option over the other. This comparison can be a helpful way to consider the tradeoffs of both options before you decide.
For instance, imagine you have two opportunities in front of you, A and B. These opportunities could be two job offers, investment options, vacuum cleaners, or just about anything else. If you choose option A instead of B, the opportunity cost of that choice would be what you could have gained had you chosen B.
In other words, opportunity cost is a measure of the roads not taken.
While opportunity cost is often a mathematical term that we can measure, you can also use it more colloquially to compare other types of opportunities.
For example, if you received invites to two parties on the same night, choosing one would incur the opportunity cost of the other. In this case, that cost may include the fun you would have had and the people you may have met at the party you chose to skip.
Opportunity Cost Formula
Learning how to calculate opportunity cost can be relatively straightforward in cases where we’re comparing two measurable options, such as investments or job contracts.
To calculate opportunity cost, you only need two inputs: the return on the option you took (the “chosen” option) and the return on the one you didn’t take (the “forgone” option). When you subtract the chosen option from the forgone option, the difference describes how much potential that choice would leave on the table.
Opportunity Cost = FO – CO
FO = Return on the forgone option
CO = Return on the chosen option
Running this formula before you make your choice can highlight if one option is much more valuable. For example, if your chosen option’s opportunity cost is high, it may be worthwhile to switch to the alternative.
When using this formula for opportunity cost, the result can be a negative value. When that happens, it means that the forgone option would offer less value than your chosen option. In other words, if the result is negative, you probably made the right choice.
Opportunity Cost Example
Analysts often use opportunity cost as a predictive metric to help them make better decisions in advance. Using it this way typically requires some estimation and prediction, so it’s not always an exact figure. However, to simplify our example, let’s try an opportunity cost calculation where we know all the numbers ahead of time.
Consider two investment opportunities you have from which to choose. Investment A will pay out a $5,000 return in exactly one year. In that same timeframe, and with the same size initial investment, investment B will yield a $6,000 return.
The opportunity cost of choosing option A would be:
$6,000 (forgone) – $5,000 (chosen) = $1,000
In other words, you would miss out on $1,000 of potential gains by choosing option A. Those missed gains would be your opportunity cost. Option B has a comparative advantage here.
For an example like this, we can easily decide to invest in option A without calculating the opportunity cost. With the same timeframe and expenses, it’s an apples-to-apples comparison, so whichever one pays more is the easy choice.
However, real-world opportunity cost calculations incorporate numerous other factors which complicate things. For instance, what if one option pays significantly more but takes much longer to achieve that return? What if one is likely to grow faster, but the other pays a hefty monthly dividend? Or if one has massive upside potential but significant risk as well?
Depending on your goals, preferences, and methods of calculating, all these factors and more can play a role in determining opportunity cost.
Why You Should Care About Opportunity Cost
Opportunity cost is a valuable metric in economics, finance, and many other fields. But you don’t need to be an economist to find some use in this nifty little calculation. More importantly than those fields, opportunity cost is a powerful decision-making tool for everyday life.
We constantly face difficult choices in life that come with implicit opportunity costs:
- Which house will you buy?
- Whose holiday party will you attend, and whose will you skip?
- Will you take the high-paying stressful job or the passion project?
- Soup or salad?
While decisions like these vary in the level of impact they’ll have on your life, what they all share is that they bring you to a crossroads. Thinking in terms of cost-benefit tradeoffs and opportunity cost is one helpful way you can navigate decisions like these.
There is not always an explicit way to measure the value of many of these outcomes. In cases like that, opportunity cost can become less of an equation and more of a scale. Place both things on that scale, and see which way you feel yourself tip.
Opportunity Cost Vs. Sunk Cost
Another figure you should consider when weighing decisions is sunk costs.
Where opportunity cost measures forgone potential gains, sunk costs describe resources that you have already committed to something.
When you buy non-refundable materials for a project, the price of those materials becomes a sunk cost as soon as you buy them. If you spend three years building a business, the time you put into it is a sunk cost.
Unlike assets and other investment capital, sunk costs are typically unrecoverable.
Sunk costs impact our decision-making, though often in a very different way than opportunity cost. The latter helps to weigh options before we select them. The former can keep us trapped in a commitment to something, even if that thing no longer benefits us. This effect is known as sunk-cost bias.
Issues With Calculating Opportunity Cost
As helpful as it can be as an estimating and decision-making device, opportunity cost is also an imperfect metric.
Since the primary purpose of opportunity cost is to form predictions, it relies heavily on estimates and assumptions. That means that opportunity cost will rarely be a 100% accurate measurement. Real-world financial matters are seldom concrete enough that we can predict precisely how they will turn out every time.
Furthermore, the burden of quantifying these various assumptions and predictions can make opportunity cost calculations quite complex.
As we saw above, the calculation for opportunity cost itself is very straightforward: subtract the value of the chosen option from the value of the not-chosen option, and you have your answer. However, the various valuations, estimates, and predictions necessary to make one-to-one comparisons can make it quite complicated to land on a single value for each opportunity.
Like most financial metrics, opportunity cost is not a be-all-end-all measurement. However, it is one tool among many that you can use to improve your investment planning, decision-making, and overall financial health.
Don’t Miss Out on Your Best Opportunities
Opportunities present themselves every day, whether we’re ready for them or not. Each of these opportunities comes with one tradeoff or another — the time spent, costs incurred, or other possibilities given up to take this one.
Deciding which chances to take and which ones to forgo can be daunting. Giving up an enticing possibility in favor of an even more enticing one can be painful. That’s why we have opportunity cost. With this simple model, we can learn to make better decisions with our limited resources, fend off regrets, and maximize the upsides.