Opportunity cost is the amount of potential gain an investor misses out on when they commit to one investment choice over another.
Learn more about opportunity cost and how you can use the concept to help you make investment decisions.
Definition and Example of Opportunity Cost
Opportunity cost is the value of what you lose when choosing between two or more options. When you decide, you feel that the choice you've made will have better results for you regardless of what you lose by making it. As an investor, opportunity cost means that your investment choices will always have immediate and future losses or gains.
- Alternative definition: Opportunity cost is the loss you take to make a gain, or the loss of one gain for another gain.
Consider, for example, the choice between whether to sell stock shares now or hold onto them to sell later. While it is true that an investor could secure any immediate gains they might have by selling immediately, they lose out on any gains the investment could bring them in the future.
While opportunity cost is not an exact measure, one way to quantify this cost might be to estimate the future value that you opted not to receive and compare it with the value of the choice you made instead.
Comparing these measures in hindsight will make them appear more concrete, but keep in mind that such an estimation is only a theoretical difference.
On a basic level, this is a common-sense concept that economists and investors like to explore. For example, what would have happened if Walt Disney had never started animating?
He might have gone on to do something equally successful, or you may not have ever heard his name. Opportunity cost is the proverbial fork in the road, with dollar signs on each path—the key is, there is something to gain and lose in each direction. You make an informed decision by estimating the losses for each decision.
How Opportunity Cost Works
When you're faced with a financial decision, you try to determine the return you'll get from each option. For example, you could be entertaining the thought of selling one bond and using the money gained to purchase another.
The opportunities can be visualized in this table:
|Weighing Opportunity Cost|
|Current Bond "A"||New Bond "B"|
|Future value could go up.||Future value could go up.|
|Future value could go down.||Future value could go down.|
If your current bond "A" has a value of $10,000, you can sell it to help purchase bond "B" at a slightly lower rate. Bond "B" has a face value of $20,000—so you've spent an additional $10,000 to purchase bond "B." To determine the best option, you need to weigh the options.
The initial cost of bond "B" is higher than "A," so you've spent more hoping to gain more because a lower interest rate on more money can still create more gains. However, you'd have to make more than $10,000—the amount that came out of your pocket—to add value to bond "B."
Every choice made in life has an opportunity cost.
In this example, the opportunity costs are continued interest gains on bond "A" and the initial loss of $10,000 on bond "B" while hoping to recover it and increase your profits in the future.
What It Means for Individual Investors
If you have trouble understanding the premise, remember that opportunity cost is inextricably linked with the notion that nearly every decision requires a trade-off. We live in a finite world—you can't be two places at once.
For investors, explicit costs are direct, out-of-pocket payments such as purchasing a stock or an option, or spending money to improve a rental property. Costs can also be wages, utilities, materials, or rent.
For example, if you own a restaurant and add a new item to the menu that requires $30 in labor, ingredients, electricity, and water—your explicit cost is $30.
Your opportunity cost is what you could have done with that $30 had you not decided to add the new item to the menu. You could have given that $30 to charity, spent it on clothes for yourself, or placed it in your retirement fund and let it earn interest for you.
Explicit and implicit costs can be viewed as out-of-pocket costs (explicit) and costs of using assets you own (implicit).
Implicit costs do not represent a financial payment. They're not direct costs to you but rather the lost opportunity to generate income through your resources.
If you have a second house that you use as a vacation home, for instance, the implicit cost is the rental income you could have generated if you leased it and collected monthly rental checks when you're not using it. It doesn't cost you anything upfront to use the vacation home yourself, but you are giving up the opportunity to generate income from the property if you choose not to lease it.
- A decision always has a lost opportunity.
- Each opportunity has losses and gains.
- Opportunity value less actual gain is an estimation of the opportunity cost.
- The same choice will have different opportunity costs for different people.