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Opportunity cost is an economic rule that savvy investors consider with every investment decision they make. But it’s also a rule that will help you make better decisions in everything you do and manage your money more effectively. In fact, pretty much every decision you make has an opportunity cost associated with it.
That’s right. Whether it’s deciding to wait in line for an ice cream or buy a new outfit using your credit card, there’s an opportunity cost involved.
In this article, we’re going to show you how to calculate opportunity cost to make better decisions in every area of your life. And we’ll show you how opportunity cost relates to your investment decisions, too.
So, What Is Opportunity Cost Exactly?
Whatever you do, there are positive and negative consequences. When you take one opportunity, you forego on another.
Take that ice cream you decide to line up for. The opportunity is to get a tasty cone of cold creaminess that will cool you in the most delicious way on a hot summer’s day. But the time you spend in the line is time that you could have spent doing something else. Like working or reading.
To take the opportunity of lining up and buying an ice cream, you give up the opportunity to use that time to do something else.
Think about a family vacation at Disneyland. You want to ride on the Big Thunder Mountain Railroad – one of the park’s most popular rides. There’s a three-hour line. Do you decide to join the line, and do nothing but shuffle along for two hours, or would your time be better spent elsewhere in the park?
You could take six or seven rides in the time you spend on waiting in line for Thunder Mountain. Will the line have shortened if you return later? When you think like this, you are calculating opportunity cost.
The choice you make needs to be the one that benefits you the most. And this choice depends upon your circumstances.
For example, let’s imagine that it’s your first day at Disneyland. You’ve got a two-day pass. You might decide to try Thunder Mountain later, and cram in as many of the less popular rides as possible on day one. The following day you could arrive early and feel more relaxed about waiting in line for your star choice.
On the other hand, if this is your one and only time at the park, and riding Thunder Mountain has been a lifelong dream, you might decide that time in line is time well spent. You’ll never get the opportunity again, so it’s now or never.
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When Should You Use Opportunity Cost?
There is an opportunity cost with almost every decision you make. If you decide to eat in one restaurant, you are foregoing the opportunity to eat in another. When you decided to read this article, you gave up the opportunity to watch television for five minutes. When you rent an apartment, you are giving up on the opportunity to use your rent money to pay a mortgage.
You may look back and consider what else you could have done with your time or money – the decisions you made at the time all had a trade-off, or opportunity cost. If you do, then you may have regrets. But you should never regret the things you do or the choices you have made.
Knowing how to calculate opportunity cost and then applying it to every decision will mean you never have those “If only I had done this instead” regrets. Because, by applying opportunity cost thinking to your decision-making, you’ll make decisions knowing what you can’t do because of the decision you have made.
How Do You Calculate Opportunity Cost?
To make the best opportunity cost decisions, you need to have a consistent method to measure the opportunity cost. Here is how to calculate opportunity cost:
Opportunity Cost = Return on the option rejected – Return on option chosen
When making this calculation, you will need to consider the following factors:
- Effort Required
Do you have the time to spare? Have you got enough money to do the thing you are considering? How much effort will it take to do?
By considering these factors, you will be able to weigh one option against another.
For example, let’s say that you have a few hours free. You’re pondering whether to spend that time at your favorite restaurant or watching a movie at home with a takeaway pizza:
- The time spent on each will be about the same. So, no decision to make there.
- The restaurant meal will cost you $50, while the pizza and film will cost you no more than $25.
- To go out, you’ve got to get showered, changed, walk or take a taxi to the restaurant and then arrange your return journey. Staying in to watch a Netflix movie and enjoy a pizza takes no more effort than to send an order on your smartphone and select a movie on your remote control.
- On the other hand, you will be foregoing a great meal at your favorite restaurant. It could close next week, and you may never get the opportunity again.
Whatever the choice you make, it will be right for you. You won’t have regrets later, because you have weighed up all the pros and cons – you’ve calculated your personal opportunity cost.
The Hidden Costs in Opportunity Cost
Not all costs can be measured easily, but they must all be considered.
Let’s say that you go to college. Some costs are easy to quantify: your books, your room, and your tuition costs, for example. You can put a dollar value on these.
Other costs are not so easy to quantify. The time you spend at college is time that you could have spent doing other things. While your qualification should lead to a higher-paying job, you could have been working and earning instead of learning.
The cost of taking a course to increase your technical knowledge may be a few hundred dollars now, but could it give you the opportunity to charge clients more for your services in the coming years? That upfront cost could be repaid many times over during the rest of your working life.
Why Does Opportunity Cost Make a Difference When You Invest?
When you invest, the act of investing stops your money from being used for other purposes. Investing money means making trade-offs. For example:
- You won’t have the cash to take advantage of a discount on a new car you want to purchase
- Nor will that cash be available to spend on emergency repairs to your home
You will also need to consider the trade-off you make when choosing one investment asset over another.
You might decide to invest in a bond, with a guaranteed return of, say, 3% over the next year. You’ve got the certainty of return. However, you could have invested in the stock market where there are no guarantees, but your investment could double (or halve).
Time and Opportunity Cost When You Invest
Time should be one of your major considerations when you consider opportunity cost and investing. Tying up your money in an investment means it will not be available to use otherwise – or you may lose money if you sell the investment early.
For example, if you make a fixed-term investment for five years and have an unexpected expense during this time, you might have to take a loan to cover the expense. This could cost you more than your investment makes.
Indeed, your investment could be worth less than your original capital because of a temporary market downturn. In addition, you may have to pay an early redemption penalty – the average early redemption fee on mutual funds is between 1% and 2%.
It’s crucial that you consider the potential implications of making investments before you make them. Giving up access to your money is a big decision. You must be certain that you won’t need the money you are investing during the period of investment.
Bring Clarity to Your Investment Decision-Making
As you can see, when you invest, your investment decision is not only about the potential return. You need also to consider the degree of safety of capital, income options if needed, and lifetime of your investment. You’ll need to consider whether you may need access to your investment capital.
This is where financial advice is needed. You should use a tried and trusted service. Like that offered by Personal Capital, which is used by more than 2 million people. Its service helps you to plan your financial future. You can link accounts, track and plan your spending, and monitor your investments. A financial advisor will be on hand to discuss your options and help you decide how different investments could help you achieve your goals.
This arms-length advice brings clarity to your decision-making. You’ll have a better idea of different investment strategies and how to allow for opportunity cost as your spending habits evolve and life events take place.
Get into the Opportunity Cost Habit
Rookie investors don’t consider opportunity cost. They never think about what they might be giving up by investing in a specific asset. These investors are those who are likely to make poorer investment decisions when they invest and have the biggest regrets when they look back.
My advice is to get into the habit of thinking about your opportunity cost in every decision you make. Even the little things come with an opportunity cost…
When you buy a coffee at Starbucks, you could have put those few dollars into the hands of a homeless person. Or you could have saved that money.
One coffee every day will cost you around $15 per week. That’s $65 per month, $780 per year. $7,800 every 10 years. In a working life, that’s around $35,000 – before inflation and return on investment is factored in.
When you spend or invest, never do so without calculating your opportunity cost. Otherwise, you might look back when you retire and wish you hadn’t treated yourself to a coffee each day.