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• In some cases, this risk can be greater than that of traditional investments.
• Because one obviously cannot buy everything, decisions must be made regarding what to buy – over other things.
• In simplified terms, it is the cost of what else one could have chosen to do.

Knowing what opportunity cost is, and how to calculate and interpret it, can help investors choose the best option for them. By using opportunity cost to construct holdings strategically, investors can mitigate volatility as well as the uncertainty of returns. Having said that, pursuing an investment strategy without first factoring in the benefits of options could cause the investor to miss out on even better outcomes.

Opportunity Cost Examples

This information should not be relied upon by the reader as research or investment advice regarding any issuer or security in particular. There is no guarantee live full service that any strategies discussed will be effective. Businesses can also apply the concept of opportunity costs, but they tend to call it economic costs.

Trade-offs take place in any decision that requires forgoing one option for another. So, if you chose to invest in government bonds over high-risk stocks, there’s a trade-off in the decision that you chose. Opportunity cost attempts to assign a specific figure to that trade-off.

The Formula

Although this result might seem impressive, it is less so when you consider the investor’s opportunity cost. If, for example, they had instead invested half of their money in the stock market and received an average blended return of 5% a year, their portfolio would have been worth more than $1 million. When considering two different securities, it is also important to take risk into account. For example, comparing a Treasury bill to a highly volatile stock can be misleading, even if both have the same expected return so that the opportunity cost of either option is 0%. That’s because the U.S. government backs the return on the T-bill, making it virtually risk-free, and there is no such guarantee in the stock market.

Why is Opportunity Cost Important for Investors to Use?

However, that meant the potentially exceptional gains these investments presented were also limited to these groups. Imagine you enjoyed the taco tremendously—and you make a habit of purchasing the same taco every single day. At the end of the month, your friend invites you to go out for drinks—but you can’t afford to go out because you have continuously spent money on tacos throughout the month. Not being able to purchase a smoothie was your short-term opportunity cost. Now, not being able to go out for drinks is your long-term opportunity cost.

What is Opportunity Cost?

Calculating the opportunity cost will also help you decide if the product is worth buying now, as well as learn to use the opportunity cost formula. While the concept of opportunity cost applies to any decision, it becomes harder to quantify as you consider factors that can’t be assigned a dollar amount. One offers a conservative return but only requires you to tie up your cash for two years, while the other won’t allow you to touch your money for 10 years, but it will pay higher interest with slightly more risk.

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He decides to close his office one afternoon to paint the office himself, thinking that he’s saving money on the costs of hiring professional painters. However, the painting took him four hours, effectively costing him $1,600 in lost wages. Let’s say professional painters would have charged Larry $1,000 for the work. Here is the way to calculate opportunity cost, along with some ways it can be used to inform your investment decisions and more.

Other Costs in Decision-Making: Incremental Costs

On one hand, you have a high interest rate for a longer period of time, but on the other,  your money is tied up that much longer and unavailable to you to invest in something else. Opportunity costs are a factor not only in decisions made by consumers but by many businesses, as well. Businesses will consider opportunity cost as they make decisions about production, time management, and capital allocation.