Opportunity cost is a basic microeconomics concept, maybe one you learned in a long-ago and hazily recollected 8 a.m. Econ 101 lecture. If you need a refresher, opportunity cost is the benefit you miss out on when you choose to do something else. Every choice you make — from investing choices to career decisions to something as simple as where to eat dinner — comes with some form of opportunity cost. There are a variety of ways it applies to your everyday life. There are a variety of ways to apply the theories of opportunity cost to your everyday life. For help making sense of how it specifically relates to investing, you may want to find a financial advisor using SmartAsset’s free financial advisor matching service.
How Does Opportunity Cost Work?
When you make a choice or a decision, you’re actually making a variety of decisions. Not only are you choosing what to do, you’re simultaneously choosing a plethora of things not to do. When you go to McDonald’s for lunch, you’re also choosing not to go to Burger King, Wendy’s or the fanciest French restaurant in town. The opportunity cost is what you give up: the delicious burgers, chicken nuggets or escargot from the establishments you shunned.
To use a more serious example, let’s say you have the choice between taking an extra shift at your job or spending the day at home with your family. If you earn $15 per hour and it’s an eight-hour shift, you stand to make $120 for your labor that day. Let’s say you choose to stay home as originally planned. Now you don’t make that $120, the opportunity cost. But let’s say you do take the shift. Now you’ll miss out on time with your family, also an opportunity cost.
Explicit Opportunity Cost vs. Implicit Opportunity Cost
The two types of opportunity costs are explicit opportunity cost and implicit opportunity cost. Explicit opportunity cost has a direct monetary value. For instance, if a restaurant buys $1,000 worth of ground beef, the cost is the other things that it could have purchased with that money, like chicken wings or hamburger buns.
Implicit opportunity cost, on the other hand, does not have a direct monetary value. If the same restaurant takes that ground beef and makes meatloaf, the implicit opportunity cost is the hamburgers it could have made and sold with the same ground beef.
You should consider both explicit and implicit opportunity costs when you are investing, building your career or running your business.
Opportunity Cost and Investing
The concept of opportunity cost is especially important when you start to think about investing. Everyone has a limited amount of money to invest. Even Warren Buffett has to make decisions, and those with significantly less cash than the Oracle of Omaha have to think even harder about where they want to put those dollars.
Let’s say you decide you want to invest in the tech sector. After doing your research, you narrow your choices down to two stocks, Company A and Company B. If you invest in Company A, you miss out on the possible gains you’d get from investing in Company B.
You can figure out your exact opportunity cost using the formula for calculating opportunity cost:
Opportunity cost = Potential value of option not chosen – Actual value of option chosen
Let’s say you decided to invest in Company A, which nets you $1,000. Investing in Company B would have netted you $1,500. You’d plug those numbers into the formula like so:
Opportunity cost = $1,500 – $1000 = $500
Thus, the opportunity cost of this choice is $500.
Another important example of opportunity cost related to personal finance arises whenever you get a paycheck. Many people deposit their paycheck directly into a checking account, where it essentially sits stagnant. While you can access it to pay for goods and services, the cash does not earn interest or grow through investment. The opportunity cost here is the money you potentially could have earned if you’d invested it, whether in a mutual fund or a certificate of deposit. This is an explicit opportunity cost because you can quantify in dollars how much you could have made had you chosen to invest your paycheck.
The Bottom Line
Opportunity cost is a fairly basic principle of microeconomics. It describes what you lose when you make a decision by considering what you could have gotten if you had made a different decision. The opportunity cost of taking a job offer, for instance, is the money you could have earned if you’d taken a different job offer.
Explicit opportunity costs can be quantified monetarily while implicit opportunity costs cannot. Consider the opportunity cost of your choices when investing, whether it’s in stocks, bonds or something else. But don’t get to the point where you become paralyzed by indecision. After all, not investing at all has the greatest opportunity cost.
- If you need help identifying investments with the least opportunity cost for you, consider finding a financial advisor. You can use SmartAsset’s free financial advisor matching service to expedite your search. You answer a few questions about your financial situation and goals. Then, we match you with up to three financial advisors in your area, all fully vetted and free of disclosures. After you talk to each advisor you get to make a decision about how to proceed.
- Diversification is important. Figure out how to build your portfolio with SmartAsset’s free asset allocation calculator.
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