In the investment world, “opportunity cost” is the cost of choosing one investment over another one that would have been more profitable. Opportunity costs are invisible on your personal balance sheet, but they are a very real consideration when making investment decisions.
First, let’s consider an example. At the beginning of the year, you receive a bonus and decide to invest it. After researching the choices, you decide to invest in high yield bonds. High yield has a decent year, returning 8%, but U.S. Treasuries have an even better year, returning 20%. That 12% difference would be your opportunity cost.
In real life, the opportunity cost is a difficult concept to pin down. Since there are literally thousands of investment choices you can make, there will always be something that you could have invested in that would have provided a higher return than the investment you picked. The best course, then, is to focus on finding investments that fit your long-term goals rather than trying to minimize opportunity costs.
How to Use Opportunity Costs for the Real-World
Having said this, there are some real-world applications of the opportunity cost concept that investors can put to work.
- Make sure you aren’t being too conservative. While a conservative approach is called for in many situations, particularly in the case of retired investors or those who will need to use their investment money for a specific purpose in a short period of time (say, the need to pay for college in a year), younger investors can afford to take more risks in exchange for better longer-term returns. As a result, taking too conservative of an approach early on – for example, a 30-year old who invests most of his or her savings in bonds – represents a significant opportunity cost over the long term.
- Keep in mind that opportunity cost is a function of time. Holding on to an underperforming investment for months, or even years, can lead to much higher opportunity costs, as can the decision to lock in a low return over a long period of time.
- Opportunity cost in investing should be viewed through the lens of your personal financial situation. Would you be better off paying down debt? If an investor earns a 6% yield on an investment, but is paying out 18% annually in credit card interest, that person is, in fact, losing money, not earning it.
- Finally, opportunity cost can occur when being fully invested keeps you from missing the chance to take advantage of significant market downturns. An investor who doesn't have the cash to put to work in a downturn will have a meaningful opportunity cost.
The Bottom Line
Opportunity cost should never be a prime consideration because it can lead you to take on more risk than you should in an effort to get the highest possible return. At the same time, it’s good to keep the concept in mind in order to keep your opportunity costs to a reasonable minimum.