Opportunity Cost

What Is Opportunity Cost?

Have you ever faced an opportunity or choice and said to yourself, "If I don't do this, I'll regret it"? In a situation where you are deciding amongst several options, there's always a benefit you miss out on that's associated with the choice(s) you don't take. This foregone benefit can be thought of as a cost to you related to making your decision and, in the field of Economics, it's referred to as an opportunity cost. The simple definition of opportunity cost is:

Opportunity Cost is the benefit foregone related to the alternative choice when a decision is made.

In other words, an opportunity cost is the regret you anticipate from not taking another option. For example, if you spend your time studying for an exam, the opportunity cost would be the time you could have spent having fun.

This concept acknowledges not just the explicit costs of a choice but also the implicit costs of what you forgo when you make that decision. Opportunity cost provides a framework for decision-making to find the most benefit, particularly for limited resources like time and money.

Within the context of investing, opportunity costs are the expected return on the investments you are evaluating. A simple example of opportunity cost in investing is in the bond markets. If you purchase bonds and hold them to maturity, they will provide a rate of return as stated. Pretend you have a bond that pays 5% and another that pays 2%, and you have $1,000 to invest. The expected return is $50 and $20, respectively. In this simple example, we can see that, all else equal, the bond paying $50 is the better choice. We can use this to illustrate how opportunity cost calculations are made.

Where
FO is the return or value of the forgone option, and
CO is the return or value of the chosen option

The return on an option is signified as the benefit minus the explicit costs of that option. In the example above, the returns are $50 and $20. For a business, the return would be the profit it makes from selling its products.

Using this formula, when the opportunity cost is positive, it means there is an alternative option with a higher potential value than your current option. When the value of this equation is a negative number, there isn't a higher value option.

The opportunity costs for these investments are as follows:

The -$30 and $30 are the opportunity costs of buying the other investment. That is, if you went with the 2% rate of return over the 5%, your "cost" or regret would be $30. In the instance where you select the 5% return investment, your "cost" is a negative $30, indicating you would not regret the decision.

This simple example helps us see how to calculate opportunity costs using the formula, but using opportunity costs has its challenges.

There are a couple of challenges to calculating opportunity costs. One challenge is that different people can value the same choices differently. In other words, they are subjective to individuals and situations. Another challenge is that in evaluating a decision, we may end up miscalculating the benefits.

Opportunity costs can be more difficult to assign numbers to when you're talking about an example like leisure time. Let's say your employer calls and offers you an extra hour of work at your job. You know the forgone benefit of saying no to your employer: it is the wages you won't earn. But what's the benefit of that time off? That might differ depending on what you do with your time, for example:

• Running an important errand
• Spending time with loved ones
• Sleeping
• Avoiding a long commute time

Thankfully, our brains are able to tell us what we value at the moment as it relates to our day-to-day lives.

In the last example, where you have an opportunity to earn an extra hour's worth of pay, we'll often neglect to consider the future value of our opportunities. If we work that extra hour and then invest those earnings in the future, it can grow to be worth much more.

There are many examples of the "skip the latte" argument in personal finance. Say you have a $5 latte every day instead of saving that $5. Over 20 years, you're not just missing out on the $36,500 you could have saved (365 days x $5 x 20 years). You're missing out on $61,655, which is the $36,500 you spent plus the investment returns you could have earned from compounding your savings for 20 years with a 5% annual investment return.

If you'd prefer to keep your latte, there are many ways to save, including reevaluating your budget, negotiating recurring expenses like insurance premiums, lowering interest rates and paying down debt.

Have you ever said or heard someone say, "I/we have already spent…" to justify why a choice is made?

Maybe you've heard a story of someone going to an outdoor concert to see an act they weren't that into in the pouring rain just because they had bought the ticket? Or a company continuing to spend money on a failing project because it had already spent a considerable amount on it? At some point, these people had a chance to reassess their situation and potentially back out, despite the costs they had already incurred. These already incurred costs are referred to as sunk costs, and they are costs you can't recover regardless of what you do.

Opportunity costs are strictly forward-looking and ignore costs you can't recover because they do not represent your benefit.

Say that a company has spent $5 million and two years implementing a new software system. They have one more year of work left and another $2.5 million to spend to complete the system. A new technology has come to the market that provides the same benefits. The new technology will take six months to implement and cost $2 million. In this example, the benefit is the same, so the opportunity costs are just the costs: one year for $2.5 million or six months for $2 million. The sunk cost is $5 million and the two years that had already been spent.

When the manager of the project starts to argue that the company has already invested $5 million in the technology, they are committing the sunk cost fallacy.

Because opportunity costs are forward-looking, to the extent that it's possible, they should include measures of uncertainty. If you're looking at a set of investment opportunities, your decision should factor in the uncertainty of gains or losses, your time horizon to recover and your subjective ability to stomach potential losses. For this reason, it's a best practice in the investment profession to match an individual's investment portfolio to their risk tolerance and time horizon.