Opportunity cost is the potential benefit of an alternative opportunity that must be sacrificed when choosing a specific action. In other words, opportunity cost measures the cost of giving up one opportunity to take another.
For example, if you want to buy a new car, you need to give up your old car and cannot do both at the same time. This means that buying a new car comes with an opportunity cost.
The old car is a perfect example of the opportunity cost in this case. There are many other examples of opportunity costs in our lives – for example, studying instead of getting a job has an opportunity cost because it means foregoing income from work and focusing on learning instead.
If you’re reading this article, chances are that you’re searching for ways to calculate opportunity cost easily. Keep reading to find out more about this topic!
When you make a decision, you have to give up something else. The cost of that decision is called an opportunity cost. It’s the value of whatever you gave up in order to take the action you took. Whether you know it or not, opportunity cost affects almost every decision you make.
Your awareness and understanding of opportunity costs will help you make better decisions and avoid some common pitfalls when it comes to money. Let’s take a look at what opportunity cost is and how to calculate it so you can make better decisions going forward.
What is opportunity cost?
Opportunity cost is simply the idea that when you choose one thing, it comes at the expense of another. For example, if you’re a student who works part-time at a coffee shop to earn extra money, you’re giving up the extra hours you could’ve spent studying.
In other words, you’re incurring an opportunity cost by working at the coffee shop. The opportunity cost of any decision is the value of the next-best alternative that must be given up in order to make that decision.
A key component of opportunity cost is that it’s subjective. What’s more important to you? That extra $100 in your pocket or the 12 hours you could’ve spent studying? That’s something only you can decide.
How to calculate opportunity cost?
The first thing to understand is that there are three types of opportunity cost:
- What you could have earned if you had chosen a different investment or savings vehicle.
- What you could’ve done with your time if you had chosen a different career path.
- What you could’ve received if you had chosen a different payment method.
Now that we’ve covered the types of opportunity cost, let’s look at how to calculate them. You can calculate the first type of opportunity costs by using a compound interest calculator.
Let’s say you decide to put $10,000 in a savings account earning 2% interest each year. After 5 years, you’ll have $11,890. That’s the opportunity cost of choosing to save in that account.
You could’ve earned $1,890 more if you had chosen a different investment or savings vehicle. You can also calculate the second type of opportunity cost by choosing one path and then comparing it to the next-best path.
Opportunity Cost = What You Give Up / What You Gain
Why is opportunity cost important?
While opportunity costs are important to consider, they’re also subjective. In other words, they depend on what’s important to you. For example, say you have the choice between two stocks.
One is a low-risk stock that’s expected to earn you 5% annually and the other is a high-risk stock that’s expected to earn you 15%. Some people would choose the low-risk stock. Others would prefer the high-risk stock. The low-risk stock is expected to earn more money.
However, the high-risk stock has a better chance of earning more money. The low-risk stock is expected to have a far lower risk and a better chance of earning money than the high-risk stock. Which stock is better? It depends on what’s important to you.
Limiting beliefs about money and self-worth
When you don’t understand opportunity costs, you’re more likely to make poor decisions. More importantly, you’re also more likely to feel guilty about those decisions, often leading to feelings of inadequacy or shame.
For example, if you decide to put $5,000 into a high-risk stock that ends up failing, you’re more likely to feel regret than if you had understood the opportunity cost of that decision. Understanding opportunity cost can help you avoid these feelings of guilt.
Also read: 20 Personal SMART Goals Examples to Improve Your Life
When you understand opportunity cost, you know that you made a decision to pursue an outcome. You didn’t fail. You chose to pursue an outcome. That outcome didn’t work out. Knowing that you could’ve made a different decision can help you avoid feelings of inadequacy and shame.
Loss Aversion
Another important aspect of opportunity cost is loss aversion. Loss aversion is the idea that we feel the pain of losing something more strongly than the pleasure we feel from gaining something. For example, let’s say you have a $100 bill in your pocket and you have the choice between two different investments.
One investment is expected to earn $100 and the other is expected to earn $800. One investment is a sure thing. The other carries more risk. Which investment do you choose? A lot of people would choose the sure thing and keep the $100 in their pocket. However, the investment that is expected to earn $800 is actually better.
Why? Because the expected loss from keeping the $100 in your pocket is far greater than the expected loss from choosing the $800 investment. If you keep the $100 in your pocket and you lose it, you’ll feel the loss. If you choose the $800 investment and it fails, you’ll feel the pain of losing that $800.
Regret aversion
Regret aversion is closely related to loss aversion. Let’s say you have a $10,000 investment that will produce a $1,000 profit. You have the choice between investing that $10,000 or putting it in a savings account that’ll give you $1,000.
Which do you choose? Most people would choose the savings account because it’s guaranteed money. However, the investment that produces a $1,000 profit is actually better.
Why? Because if you choose the savings account, you’ll feel no regret. However, if you choose the investment and it fails, you’ll regret the decision.
Types of Opportunity Costs
- What you could have earned if you had chosen a different investment or savings vehicle.
- What you could’ve done with your time if you had chosen a different career path.
- What you could’ve received if you had chosen a different payment method.
You can also approach the concept of opportunity cost from a different angle. What would happen if you didn’t make this decision? How would your life be different? How would your finances be different?
Simply asking these questions can help you identify areas where opportunity cost is important.
Money Mistakes Due to Lack of Understanding of Opportunity Cost
If you don’t understand opportunity cost, you’re more likely to make a few common money mistakes. Let’s take a look at some of the most common ones.
- Not maximizing your savings. If you don’t understand opportunity cost, you may be tempted to spend every last dollar you have. While there’s nothing wrong with spending money, you should always make sure you’re saving at least 10% of your income.
- Not diversifying your investments. If you don’t understand opportunity cost, you might get tempted to put all of your money in one investment. While it’s tempting to put all of your eggs in one basket, this is a strategy that often fails.
- Not paying yourself first. If you don’t understand opportunity cost, you may be tempted to spend all of your income. To avoid this temptation, make sure you’re paying yourself first.
Deciding whether to invest or save
As you can see, there are benefits and drawbacks to both investing and saving. When deciding between the two, you should consider both the benefits and drawbacks of each. You may want to take a look at your long-term goal and see which will help you get closer to that goal the most.
Alternatively, you may want to consider your risk tolerance. Are you the type of person who can stomach the ups and downs of the stock market? Or do you prefer the stability of a savings account? Understanding opportunity cost can help you make a more informed decision.
