If you took basic economics in high school or college, you might remember a discussion on the concept of opportunity cost, or the relative cost of doing one thing and not something else.
This provides a useful framework for making decisions in many aspects of life, especially when it comes to your investment portfolio. But opportunity cost isn’t the most intuitive concept, at least not at first blush.
So, here’s a quick primer that will help you make smarter investment decisions.
Weighing Two Options Through the Framework of Opportunity Costs
The simplest way to illustrate how opportunity costs work is to imagine a scenario in which you have a choice between two decisions. Below, economist Paddy Hirsch does a nice job of doing this with the example of a restaurateur who is trying to decide whether his next venture will be a soup and salad place, or a steakhouse.
If the restaurateur opts for the soup and salad option, then the opportunity cost of that decision, Hirsch shows, is the money he doesn’t make as a steakhouse owner.
When describing the opportunity cost of a decision, you express that in terms of the option you chose not to take. Study.com has a helpful lesson on this. In its hypothetical example, a farmer is making a choice between growing rice or growing wheat:
“The opportunity cost of producing rice will always be in terms of wheat, and the opportunity cost of producing wheat will always be in terms of rice. The opportunity cost of choosing one possibility is the value of the possibility you gave up. It’s what you sacrificed. It’s not what you chose, but it’s the next best alternative.”
Now, expand this idea to include the normal expenses and investments a person has in her everyday life. Kevin at Invest It Wisely offers the example of someone who is thinking about dropping $1,000 on a new TV.
The opportunity cost of that TV goes beyond that four-figure stack of cash. That’s also $1,000 you aren’t spending to pay off a mortgage, to save for a vacation, or to invest in your children’s education, he writes.
When you think about expenses and investments in terms of opportunity costs, it makes prioritizing things easier, or at least creates a useful framework for establishing these priorities. When you describe a new TV as costing you a week long vacation or a mortgage payment, then you are forced to question the relative values of these options.
And once you start putting real numbers to these decisions, you have a data-driven method for prioritizing what you spend your money on, or what you invest in.
A Simple Formula for Calculating Opportunity Costs
Investopedia has a concise and perfect formula for calculating opportunity cost, and it can apply to everything from huge enterprises that have portfolios of projects to individual investors and their own portfolios.
Here’s their formula:
Opportunity Cost = Return of Most Lucrative Option – Return of Chosen Option
Investopedia gives the example of a company deciding what to do with profits: Invest in the stock market, or reinvest in the company to improve efficiencies and lower operating costs.
In that example, the stock market option predicts a 12 percent ROI; the reinvesting of profits predicts a 10 percent ROI.
So, if the business decides to reinvest profits you get this math:
Opportunity Cost = 12 percent returns – 10 percent returns = 2 percent
That 2 percent difference in predicted ROI is the opportunity cost that business faces if it decides to reinvest profits in the company rather than in securities.
Now, let’s take a look at how this same math can be applied to an individual’s investment portfolio.
Applying This to Your Investments — And a Warning
Think about the previous example of the company that decided to reinvest its profits. To think strictly in terms of ROI misses a lot of nuance in real-world decision making. For example, investing in the company might have unforeseen knock-on effects such as improving employee morale or making the company much better positioned to attract the most talented job-seekers.
Thinking purely in terms of ROI and opportunity cost when evaluating your portfolio creates the same myopic problems. Thomas Kenny at The Balance offers the example of someone who has received an end-of-year bonus and wants to invest that money.
The two options put forth: High-yield bonds with an 8 percent rate of return, or US treasuries with a rate of return of 20 percent. On paper, choosing the bonds exposes the investor to an opportunity cost of 12 percent, the difference between those returns.
But investing is seldom so cut-and-dried, Kenny says. “In real life, the opportunity cost is a difficult concept to pin down. 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. The best course, then, is to focus on finding investments that fit your long-term goals rather than trying to minimize opportunity costs.”
Cash and Capital: Understanding Opportunity Costs Will Make You a Smarter Investor
When considering your own investment goals and your own strategy, opportunity cost provides a useful framework for figuring out what you want to do with your savings and your cash.
Let’s start with the example offered by personal finance blogger Stefanie O’Connell, who says she amassed $29,500 in capital over five years between 2011 and 2016. She offers three scenarios for what could be done with that money:
- Do nothing. The money doesn’t build value over those five years (and, in fact, its value erodes due to inflation), but it remains easily accessible.
- Put it in a high-yield savings account that earns 1 percent annually. Over five years, that’s $1,475 in simple interest. So, the opportunity cost of keeping your cash in your mattress or wherever versus putting it in this kind of account would be $1,475.
- Invest in things like securities that historically have a higher rate of return. O’Connell chose this option, and she reports that her $29,500 has yielded about $6,000 in five years. So, the opportunity cost of high-yield savings accounts is $6,000-$1,475, or $4,525.
But this isn’t to say that you shouldn’t hold onto cash — most advisors will recommend that cash represents some proportion of the composition of your portfolio, and there are two good reasons for this. One, you simply need to have access to some amount of cash. Two, as Sham Gad writes at Seeking Alpha: “Capital that one invests today is money that can’t be invested next month. Of course, you could sell anytime, but you would be at mercy of Mr. Market’s offer on that particular day.”
Overtime pay, at least in theory, works on the same principle: An employee has just 168 hours available in a week, and he will sell 40 of those hours to his employer for X. But hour 41 and any subsequent hours would cost the employer 1.5X because those hours cut into things like leisure time, or the time that employee could spend with this family.
“Each incremental amount of invested capital has a higher opportunity cost than the capital that preceded it,” Gad says. “So, when I’m looking to allocate capital, with respect to my final 20% cash position, my upside requirements are going to be a lot higher than the preceding 20%, and so forth.
“So, unless I’m presented with arbitrage or special situation type investments, I’m looking for a two- to threefold return before making further investment decisions at current market valuations.”