What Is Opportunity Cost?
When an investor is analyzing and comparing investments, opportunity cost is the potential gain the investor gives up by not choosing an investment alternative. Read on to learn about the theory behind opportunity cost and how to use it to analyze and choose investments.
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Theory Behind 'Opportunity Cost'
Opportunity cost is a term in economic theory that refers to the cost of a particular activity as a loss of value or benefit incurred by foregoing an alternative activity. The "cost" here does not refer to an out-of-pocket expense (or explicit cost) but rather a value (or implicit cost) assigned to the foregone opportunity.
A common application of opportunity cost is with business finance decisions. For example, a company may compare the potential returns of two different capital projects before choosing the best alternative. To calculate the opportunity cost, the business would subtract the potential return on the chosen opportunity from the potential return on the foregone opportunity, or the one not chosen.
Example of opportunity cost calculation:
Opportunity Cost = Potential Return on Foregone Opportunity - Chosen Opportunity Potential Return
| Foregone Opportunity Potential Return | 12% |
| Chosen Opportunity Potential Return | 10% |
| Opportunity Cost | 2% |
12% - 10% = 2%
Using Opportunity Cost to Make Investment Decisions
For an investor, opportunity cost can be calculated by subtracting the potential return of a chosen investment opportunity from the potential return of an investment not chosen.
Opportunity Cost = Potential Return on An Investment Not Chosen - Potential Return of a Chosen Investment
For example, choosing an investment with a potential return of 10%, rather than an investment with a potential return of 7%, results in an opportunity cost of 3%.
10% - 7% = 3%
Once the opportunity cost analysis is complete, an investor may also consider other factors, such as market risk, that may be difficult to quantify in the analysis. For example, a risk averse investor may consider the risk of an investment in relation to its expected return more important than its opportunity cost. Thus, opportunity cost is not always the deciding factor when making the final investment choice.
Note: The idea of behavioral finance suggests that investors don't always think and behave according to potential for returns alone. For example, an investor may be willing to give up a higher risk and a higher potential return on stock investment in exchange for a lower risk and a lower potential return on a bond investment. The opportunity cost may be relatively high for this decision but a lower-risk choice was the priority for the investor.
Opportunity Cost vs. Sunk Cost
Opportunity cost is the cost of a foregone alternative opportunity, such as a higher gain that is missed on one investment by choosing an alternative investment with a lower return. This cost represents an estimate and has not been incurred. However, sunk costs are costs that have already been incurred, such as an investment that was made in the past. These costs cannot be saved by the company and theoretically should be ignored when making decisions.
Risks & Limitations of Thinking About Opportunity Cost
The limitations of opportunity cost include the difficulty in accurately predicting future returns and in measuring the varying degree of market risk between alternatives. While historical data can help with forecasting returns, the actual opportunity cost can only be known in hindsight and market risk is not included in the opportunity cost calculation.
For example, if an investor is considering a stock investment, they may be able to research the average stock market return to get an idea of what to expect for future performance. If their alternative is a bond investment, they may also research historic bond market returns. However, since past performance is no guarantee of future results, the ultimate decision may be made by considering additional factors, such as the investor's feelings about risk.
Bottom Line
In simple terms, opportunity cost refers to what is given up by choosing one option over one or more other options. For an investor, this cost is the difference between the return of the investment not chosen versus the investment that is chosen. Investors may consider other factors, such as risk and time horizon, in addition to opportunity cost.
This article was written by
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