DEFINITION The amount of potential gain that an investor misses out on when they commit to one investment over another is known as opportunity cost.
The term "opportunity cost" is defined and illustrated with an example.The value of what you lose when you have to choose between two or more options is known as opportunity cost. When you make a decision, you believe that the outcome will be better for you, regardless of what you lose by doing so. As an investor, opportunity cost refers to the fact that your investment decisions will always result in current and future losses or gains. Alternative definition: Opportunity cost is the loss you incur in exchange for a gain or the loss of one gain in exchange for another. Consider the decision of whether to sell stock shares now or hold on to them for a later sale. While it is true that an investor can protect any immediate gains by selling right away, they lose out on any future gains the investment could bring them. While opportunity cost isn't an exact measure, one way to estimate it is to compare the value of the choice you made instead to the value of the future value you didn't receive. Note: In retrospect, comparing these measures makes them appear more concrete, but keep in mind that this is only a theoretical difference. On the surface, this appears to be a straightforward concept that economists and investors enjoy exploring. What would have happened, for example, if Walt Disney had never started animating? You may have never heard of him, or he may have gone on to do something equally successful. The proverbial fork in the road with dollar signs on each path is opportunity cost; the key is that there is something to gain and lose in each direction. You make an educated decision by calculating the losses associated with each option.
How Opportunity Cost Is CalculatedWhen faced with a financial decision, you try to figure out how much money you'll make from each option. For example, you might be considering selling one bond and using the proceeds to buy another. The following table depicts the possibilities: Considering the Opportunity Cost New Bond "B" Current Bond "A"
|Current Bond "A"||New Bond "B"|
|It's possible that the value will increase in the future.||It's possible that the value will increase in the future.|
|It's possible that the value will decrease in the future.||It's possible that the value will decrease in the future.|
Individual Investors: What Does It Mean?If you're having trouble grasping the concept, keep in mind that opportunity cost is inextricably linked to the idea that almost every decision involves a trade-off. Because we live in a finite world, you can't be in two places at the same time.
Explicit ChargesExplicit costs are direct, out-of-pocket payments made by investors, such as the purchase of a stock or option or the expenditure of funds to improve a rental property. Wages, utilities, materials, and rent are all examples of costs. Your exact cost is $30 if you own a restaurant and want to add a new item to the menu that costs $30 in labour, ingredients, electricity, and water. The amount of money you could have saved if you hadn't added the new item to the menu is your opportunity cost. You could have donated $30 to charity, spent it on clothing for yourself, or put it in your retirement account to earn interest. Note: Out-of-pocket costs (explicit) and costs of using assets you own are examples of explicit and implicit costs (implicit).
Costs that aren't explicitImplicit costs are not monetary payments. They're not direct costs to you; rather, they're the missed opportunities to earn money with your resources. The implicit cost of owning a second home that you use for vacations is the rental income you might have made if you had leased it and received regular rent payments when you weren't using it. You won't have to pay anything to use the vacation home yourself, but you will miss out on the opportunity to earn money from it if you don't lease it.
Important Points to Remember
- A missed opportunity is always present in a decision.
- There are advantages and disadvantages to each opportunity.
- The opportunity cost is calculated by subtracting the opportunity value from the actual gain.
- Different people will have different opportunity costs when making the same decision.