When it comes down to personal finance, there is one economic concept that goes unnoticed many a times and that is ‘opportunity cost’.
‘Opportunity cost’, or in other words, the cost of a missed opportunity, is simply how choosing one investment opportunity over another one that would have been more profitable can prove costly.
When it comes down to personal finance, there is one economic concept that goes unnoticed many a times and that is ‘opportunity cost’
With more household incomes stretched to the limits in the wake of the global economic slowdown, this principal is quickly becoming a budgeting essential.
From our careers and our individual housing situations to how we invest and where to go to school, understanding the opportunity costs concerning these decisions is key for a sound financial footing.
Since there are literally thousands of investment choices you can make, there will always be something that you could have invested in that would have provided a higher return than the investment you picked.
Although it is considered widely to be more of a theoretical investing concept and estimating such a cost may be a difficult concept to nail down in real life, individuals, investors or business owners can use it to make educated decisions when they have multiple options before them.
Individuals, investors or business owners can use the concept to make educated decisions when they have multiple options before them.
Because by definition they are unseen, opportunity costs can be easily overlooked if one is not careful. Understanding the potential missed opportunities foregone by choosing one investment over another allows for better decision-making.
Each choice has benefits and drawbacks. If you opt for the meal, you may be able to splurge on a nice lunch while taking a break from your routine food.
But if you choose to save the money, you give up that break and good food, but you get the chance to earn interest on that Dh100.
Opting the second choice would give you more money in the future. Either way, you stand to gain and lose something. Every time you make a choice, you're weighing the opportunity cost of that action.
Opportunity costs extend beyond just the monetary costs of a decision
Opportunity costs extend beyond just the monetary costs of a decision, but it includes all real costs of making one choice over another, including the loss of time, energy and a derived pleasure/utility.
Another option is to reinvest your money back into the business, expecting that updated software or better equipment will increase production efficiency, leading to lower operational expenses and a higher profit margin.
Assume the expected return on investment in the stock market is 8 percent over the next year, and your company expects the new equipment to generate a 5 percent return over the same period.
The opportunity cost of choosing the equipment over the stock market is (8% - 5%), which equals three percentage points. In other words, by investing in the business, you would forgo the opportunity to earn a higher return.
Let’s look at another illustration, but this time from the world of market investments.
Let’s consider two companies, company A and company B, that has a per share price of Dh10 each. Say you decide to buy 1,000 shares of company A at Dh10 a share, would yield you Dh10,000.
While 1,000 shares in company A might sell for Dh12 a share after a month, netting a profit of Dh2,000, during the same period, company B increased in value from Dh10 a share to Dh15.
In this scenario, investing Dh10,000 in company A netted an yield of Dh2,000, while the same amount invested in company B would have netted Dh5,000.
The Dh3,000 difference is the opportunity cost of choosing company A over company B.
How to calculate and key risk associated
While there is no hard and fast mathematical formula for figuring out opportunity costs, that doesn't mean you can't weigh considerations that could sway cost decisions in one direction or another.
The general formula to calculate ‘opportunity cost’ is subtracting the return of the option that was chosen from the return the foregone investment opportunity that could have been availed.
By and large, opportunity costs are all about options - and weighing those options before choosing one alternative or another.
The goal here is making a decision that leads to value, i.e., what am I getting out of sacrificing one outcome, be it financial or lifestyle-oriented, and what am I gaining out of making an opportunity cost decision?
Here is the key risk to calculating such an opportunity cost. As a forward-looking calculation, the actual rate of return for both options is unknown.
If the selected securities decrease in value, the business could end up losing money rather than enjoying the expected 12 per cent return.
It is equally possible that, had the company chosen new equipment, there would be no effect on production efficiency, and profits would remain stable.
Key takeaways when applying opportunity costs in the real world
Every purchasing decision you make has a cost. When you are faced with more than one option, the cost differential (cost savings) is simply the out-of-pocket difference between the two (or more) choices.
As a forward-looking calculation, the actual rate of return for both options is unknown.
It is also useful to analyze the opportunity cost of choosing one option over another.
This can be done by estimating how much you could potentially earn by investing the difference (investing the cost savings) between the two options.
Also you can apply this to regular everyday purchases and choosing between going to restaurants vs. cooking at home, buying cigarettes vs. not buying cigarettes.
In each case, the opportunity cost of choosing one alternative over the other would entail figuring out how much you could earn if you invest the difference in cost between the two options.
Knowing when to be conservative when investing is key when analyzing opportunity costs depending on your respective situations.
Being conservative is validated if you have to use your investment money for a specific purpose in a short period, like in the case of retired investors or say, the need to pay for college in a year.
Knowing when to be conservative when investing is key when analyzing opportunity costs depending on your respective situations.
But apart from that, if are investing while young you can afford to take more risk in exchange for better longer-term returns.
On the other hand if you taking too conservative of an approach early on – for example, a 30-year old who invests most of his or her savings in bonds – represents a significant opportunity cost over the long term.
Keep in mind is that opportunity cost is a relative of time.
What this means is holding on to an underperforming investment for months or even years can lead to much higher opportunity costs, as can the decision to lock in a low return over a long period of time.
Investing during a market downturn has historically proven to be a rewarding and an opportunity for most. Missing out on such investing could again up your opportunity costs.
Investing during a market downturn has historically proven to be a rewarding and an opportunity for most.
For example, in late 2011 the bond market lost 12 per cent of its value, but in the following month, it rebounded with a return of over 10 per cent.
An investor who didn’t have the cash to put to work in this downturn had to turn down a meaningful opportunity cost.
It is simply the difference between the price that consumers pay and the price that they are willing to pay.
Let’s now break it down!
The maximum price a buyer is willing to pay is called the Buyer’s Reservation Price. The Direct Opportunity Costs of an alternative, say A, are for instance direct net payments that have to be made in order to obtain A.
Typically, the direct opportunity costs are simply the nominal price plus other direct (out-of-pocket) expenses of the alternative.
How to calculate?
The Net Benefit of an alternative is the benefit of the alternative minus its opportunity costs.
The Consumer Surplus of an alternative is the benefit of the alternative minus the direct opportunity costs.
The Indirect Opportunity Costs of an alternative is the benefit minus the direct costs of the next best alternative.
Finally, the (Total) Opportunity Costs of an alternative is the sum of its direct and indirect opportunity costs.
