Just like your money, the opportunity cost compounds too!
According to John Stuart Mill, Opportunity cost is the loss of potential gain from one option over another. In other words, what else could I have done with my money? For example, every time you decide to go for a night out, spend $100 on drinks rather than buying groceries.
In investing and financial context, opportunity cost is when you choose to invest your money in bonds and get a dismal rate of return. In contrast, you could use that money to invest in stock and potentially get more in return. You miss out on buying one option over another comparable option.
For investments you plan to make in the future, often, there won’t be a reliable and straightforward formula to calculate the opportunity cost. Because you don’t know for sure how the asset you’re comparing will perform in the future.
You are stuck between buying one of the two stocks. You decided to buy stock A over stock B and hold it for one year. It doesn’t increase in price or give out dividends for one year. On the other hand, stock B soared and doubled in value over the same period. Even though you didn’t lose money on stock A, it makes you uncomfortable to miss out on all the gains compared to stock B.
When you stay on the sidelines with investing your money. You miss out on the potential return, and your cash loses buying power thanks to inflation.
One should view the opportunity cost through the lens of personal financial situation. Would you be better off paying your debt? An investor earning a yield of 6%, in reality, loses 12% if he’s got a credit card to pay off charging interest at or above18%.
How do you calculate the opportunity cost?
In economics, opportunity cost is the expected return on forgone minus the expected return on the chosen investment.
Opportunity cost = Potential ROI on forgone investment — Potential ROI on chosen investment.
When calculating opportunity cost, it’s essential to consider more than just the flat return. You should also weigh the level of risk involved between the options.
In investing, generally, the higher the risk higher your returns, but that doesn’t always hold. With that in mind, it can be hard to calculate the opportunity cost of investing.
How does opportunity cost affect you?
No one chooses the wrong investment and incurs a higher opportunity cost. Your knowledge of op cost influences decisions around what to invest in. The next step for you is to evaluate every stock and investment to optimize your rate of return.
The actual cost of any purchase isn’t the dollars you paid for it. Instead, it’s the opportunity cost — the value of an investment you didn’t make because you used your funds to buy something else.
— Warren Buffett
Thankfully, after years of analysis and testing have given us the Portfolio Theory. It takes most of the heavy lifting of finding the perfect stock or a company out of the equation. As long as your investments are well diversified among sectors and economies, you can potentially gain better returns over time while keeping the risk exposure the same as that of the market.
A carefully constructed portfolio gives a clear guideline for how much you can invest in a one-sector before the risk associated with the investment outweighs the return. These guidelines are usually based upon individuals investment objectives. For example, Cedrick, thirty years old, working full-time and is good with his money. He can afford to take more risk in his investment strategy to increase his returns. However, uncle Ken, 53 years old man with five years left on his mortgage, can’t afford to take a substantial risk with his investments as he may not have enough time to recover if things were to go south.
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