What is opportunity cost?
Opportunity cost is a fundamental concept that represents the potential benefits that an individual, investor or business misses out on when choosing one alternative over another. In simple terms, it’s what you miss out on when you make a decision. Understanding the potential missed opportunities when an individual or business chooses one investment over another allows for better decision making and provides a more successful result in the future.
For example:
Imagine you have $10,000 to invest, and you have two investment options:
Option 1: You can invest the $10,000 in stocks, which historically have provided an average annual return of 8%. However, it is a higher risk investment.
Option 2: You can invest the $10,000 in bonds, which historically have provided a safer but lower average annual return of 4%.
If you choose option 1 and invest in stocks, you have the potential to earn an average annual return of 8%. However, the opportunity cost in this case is the potential return you could have earned if you had chosen option 2, which is 4%.
So, in this investing scenario, the opportunity cost of choosing stocks over bonds is 4% per year. By investing in stocks, you have the potential for higher returns, but you’re giving up the safer but lower returns associated with bonds.
This example illustrates how opportunity cost can help investors weigh the potential benefits and risks of different investment choices. It highlights that choosing one investment over another involves considering not only the potential gains but also what you might be forgoing in terms of returns or safety.
Opportunity cost isn’t solely used for large financial decisions, it can also be used in our day-to-day decision making.
For example:
You have $500 to spend on a weekend getaway, and you’re deciding between two options:
Option 1: You can use the $500 to go on a spontaneous weekend trip with your friends, enjoying a fun and memorable experience.
Option 2: You can save the $500 and put it towards a down payment on a new laptop, which you need for work or school.
If you choose Option 1 and go on the weekend getaway, the opportunity cost is the new laptop you could have purchased to enhance your productivity or education.
Conversely, if you choose Option 2 and save the $500 for the laptop, the opportunity cost is the enjoyable weekend experience with your friends.
This example illustrates how opportunity cost applies to everyday spending decisions. It forces you to consider the trade-offs between immediate enjoyment and long-term benefits or necessities. Deciding how to allocate your money involves weighing the value of the experiences and items you could have enjoyed against the value of what you’re choosing to prioritise.