Any effort to predict opportunity cost must rely heavily on estimates and assumptions. There’s no way of knowing exactly how a different course of action will play out financially over time. Investors might use the historic returns on various types of investments in an attempt to forecast their likely returns. However, as the famous disclaimer goes, “Past performance is no guarantee of future results.” In the investing world, investors often use a hurdle rate to think about the opportunity cost of any given investment choice.
Opportunity cost vs. sunk cost
If the business goes with the securities option, its investment would theoretically gain $2,000 in the first year, $2,200 in the second, and $2,420 in the third. John Schmidt is the Assistant Assigning Editor for investing and retirement. Before joining Forbes Advisor, John was a senior writer at Acorns and editor at market research group Corporate Insight. His work has appeared in CNBC + Acorns’s Grow, MarketWatch and The Financial Diet.
What Is Opportunity Cost?
- If we want to answer the question, “how many burgers and bus tickets can Charlie buy?
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- As with many opportunity cost decisions, there is no right or wrong answer here, but it can be a helpful exercise to think it through and decide what you most want.
- Trade-offs take place in any decision that requires forgoing one option for another.
- You can study historical data to give yourself a better idea of how an investment will perform, but you can never predict an investment’s performance with 100% accuracy.
That’s a real opportunity cost, but it’s hard to quantify with a dollar figure, so it doesn’t fit cleanly into the opportunity cost equation. You chose to read this article instead of reading another article, checking your Facebook page, or watching television. Your life is the result of your past decisions, and that, essentially, is the definition of opportunity cost. If we plot each point on a graph, we can see a line that shows us the number of burgers Charlie can buy depending on how many bus tickets he wants to purchase in a given week.
Limitations of Opportunity Cost
The opportunity cost attempts to quantify the impact of choosing one investment over another. Second, the slope is defined as the change in the number of burgers (shown on the vertical axis) Charlie can buy for every incremental change in the number of tickets (shown on the horizontal axis) he buys. The slope of a budget constraint always shows the opportunity cost of the good that is on the horizontal axis. If Charlie has to give up lots of burgers to buy just one bus ticket, then the slope will be steeper, because the opportunity cost is greater.
How Opportunity Costs Impact You as an Investor
Sunk costs should be irrelevant for future decision making, while opportunity costs are crucial because they reflect missed opportunities. That’s not to say that your past decisions have no effect on your future decisions, of course. You’ll still have to pay off your student loans whether or not you continue in your chosen field or decide to go back to school for more education.
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. 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 each time you choose one option over another, you’ve lost out on something. While the concept of opportunity cost applies to any decision, it becomes harder to quantify as you consider factors that can’t be assigned how to start a virtual bookkeeping business in 5 simple steps 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.
It’s obvious that decisions around what to invest in are inherently informed by opportunity cost. But once you understand opportunity cost is a factor you should weigh, the amount of opportunities to consider may seem intimidating. You don’t want to choose the wrong investment option and incur the wrong opportunity cost, after all. Everyday examples of https://www.online-accounting.net/9-steps-to-manually-reconcile-a-bank-statement/ opportunity costs might include choosing to commute using public transit for 80 minutes instead of driving for 40 minutes. You might save on the cost of gas but double the trip length and miss out on other things you could have done during that time. Opportunity costs are a factor not only in decisions made by consumers but by many businesses, as well.
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. While opportunity costs can’t be predicted with absolute certainty, they provide a way for companies and individuals to think through their investment options and, ideally, https://www.online-accounting.net/ arrive at better decisions. Assume that a business has $20,000 in available funds and must choose between investing the money in securities, which it expects to return 10% a year, or using it to purchase new machinery. No matter which option the business chooses, the potential profit that it gives up by not investing in the other option is the opportunity cost.
A former Wall Street trader, he is the author of the books CNBC’s Creating Wealth and The Career Survival Guide. His work has appeared on TheStreet.com, US News, CBS News, Fox Business, MSN, Motley Fool, and other major business media platforms. “Opportunity costs means “What else could I have done with my money? ” says Adem Selita, chief executive officer at The Debt Relief Company in New York, N.Y. “Expert verified” means that our Financial Review Board thoroughly evaluated the article for accuracy and clarity.
