Opportunity cost is the trade-off among a variety of choices
Opportunity cost allows you to make better decisions in life and investing.
Understand opportunity cost
Opportunity cost refers to the potential benefits that an investor or business will lose out when picking one option over another. In other words, opportunity cost is the cost of sacrificing another opportunity.
Opportunity cost is an important concept for both life and investing.
It helps us make better decisions. In reality, we can't have everything we want, and we must make choices in various scenarios. The key is to make a decision that will maximize your interests. Considering the opportunity cost tells you the most cost-effective way to spend your resources.
Opportunity cost can simply be calculated by comparing the return on best foregone option and the return on the chosen option, and the formula is:
Opportunity Cost = Return on Best Foregone Option - Return on Chosen Option
Suppose you have Option A- a job offer with an average monthly salary of $4,000. Meanwhile, Option B offers a job with an average monthly salary of $5,000. But you like Job A better. In this case, the opportunity cost of choosing Option A is equal to the extra $1,000 you couldn't earn each month.
However, opportunity cost sometimes doesn't show as an explicit cost, which will always have a dollar value. If choosing option A provides you with a better career path, it may bring you more benefits in the future. That's why it's important to consider not only the current opportunity cost but also the long-term one.
In terms of investing, opportunity cost can be used to make investment decisions by calculating the difference in the returns of each investment you're considering. Let's have a look at a real-world example.
Suppose you are considering whether to buy a house. The potential return on this investment would be the monthly rent and the increased value of the house over time.
But you can also invest your money into the stock market. Your return on the stock market would be the dividends and the potential capital gains in the future.
If you choose to buy a house instead of investing in the stock market. You will incur such opportunity cost:
Opportunity Cost = (Dividend Returns + Capital Gains) - (Rent + Increased House Value)
Keep in mind, calculating opportunity cost is only to help you make decisions, which doesn't guarantee that you will get the same returns as expected.