The Impact of Opportunity Cost
Do you know what opportunity cost means? How about the impact of opportunity cost? Is this something you should concern yourself with? The truth is if you don't consider this concept, it could cost you significant amounts of missed opportunities.
People avoid the concept of opportunity cost because it's abstract. It's not something that is published on most websites and it's not a straightforward calculation. It is possible to calculate an opportunity cost, but it has to be done in the context of the problem at hand.
Investopedia defines the concept of opportunity costs as:
Opportunity costs represent the benefits an individual, investor or business misses out on when choosing one alternative over another.
I Want Candy
To grasp the concept of opportunity cost, think back to your childhood when you received an allowance every week or month. The amount you received from your parents wasn't much. But, you tried to make the best of it.
Your friends invite you to go the local candy store. You decide to buy the candy bar you always buy because it's your favorite. But, one of your friends mentions that he read about this great new candy bar. The candy store owner stocked up on this new candy bar. Obviously, he read the same report as your friend. Your friends all decide to buy this great new candy bar, but you've already spent your money on your usual candy bar.
Your friends proceed to tell you how wonderful this new candy bar is. You won't get to experience the joy of this new taste until your next allowance payment. Maybe one of your friends will let you try it, but they are enjoying it too much to give up any significant portion of the candy bar.
The opportunity cost in this example would be your inability to taste the wonderful new candy bar that all your friends are raving about. Understand that if the new candy bar flopped with your friends, the opportunity costs shift in your favor. By sticking to your choice of your favorite candy bar in this case, your friends' opportunity costs would be that they didn't choose the status quo.
There is no hard number that you can assign as a cost in this example because it's not easy to associate a number to the taste of foods. People try to do it with food and wine, but there are wide variations even with this. For instance, some people could easily spend thousands of dollars on a bottle of wine and will justify that it tastes better than bottles of lesser cost. Most others would think paying that much for a bottle of wine is insane.
Opportunity cost must be analyzed from the perspective of the person who is contemplating the opportunity. For instance, you may think paying thousands for a bottle of wine is worth every penny you pay. However, someone else wouldn't pay anywhere near that much for a bottle of wine. They are happy with their $20-$30 bottle of wine. The other person does not have an opportunity cost of not buying the bottles priced at thousands of dollars even if you think they are missing out.
Conversely, if you pay thousands for one bottle of wine and it turns out to be bad, you may have spent your entire budget on that one bottle, and you won't be able to enjoy wine again until your next payday.
In the investing world, investors will try to normalize their choices so they can compare apples to apples. For instance, if you are looking to compare the opportunities of two bonds, you'll need to compare bonds that have similar credit quality (more about risk below). Otherwise, you'll have to adjust your price to account for the differences of bonds regarding credit quality. A lower-quality bond will be more expensive to counteract taking on more risk.
Can Opportunity Costs Be Quantified?
It is possible to quantify some opportunities compared to others. For instance, if you make an investment and it gains 4% but you did not take advantage of an investment that earned 7%, then your opportunity cost is the difference of 3% (7% - 4%).
Obviously, your opportunity costs change as time progresses during an investment. For instance, you won't be earning the 7% right away. It will take time. Therefore, your opportunity cost is the 3% difference until your investment meets the objective of 7%. The 4% investment may be less risky which means you will have a better chance of receiving 4% by taking on the less risky investment. If your investment in the 7% instrument doesn't pan out, you would have lost out on receiving 4%. You risk could be more than the 3% if the original amount you invested is worth less than what you paid.
Do We Need to Care About Opportunity Costs?
Because it's hard to pin down an opportunity cost, it makes it difficult for investors to grasp the concept. You may wonder if it's even necessary to worry about? The answer is it does make a difference, even if subtle. Imagine if you are the head of finance for a company. Your boss wants you to find ways to maximize the investments the company makes. To do that, you'll need to evaluate several opportunities and choose the ones that have the potential to give the largest returns. This means you'll have to understand the opportunity costs of choosing one investment over another.
How will you know which investment to choose? This is where it becomes more art than science. When investing in stocks, you can analyze the financial statements of potential companies and choose ones that have the strongest economics. However, companies can use accounting tricks that will fool many an unsuspecting investor. When you learn about these tricks, though, you can detect them and take action. But, like anything else, there are no guarantees.
When you are diligent with your analysis, you will find investments that will pan out and those will more than make up for a few duds you hit along the way. Have a portfolio of solid companies rather than one or two. Don't put all your eggs in one basket, as you have likely heard.
Risk Plays a Role
You can't evaluate any investment without taking into consideration the risk involved. You can compare ratios until you're blue in the face. If you don't factor in the risks, the higher risk companies are likely to bite you in the you-know-where.
Hopefully, you'll catch the higher risk companies when you comb through the financials for the company. You'll learn to recognize the red flags.
Opportunity cost plays a role when evaluating risk because you could choose a safe investment like a risk-free rate which means you'll likely get the low returns promised by that instrument. However, when you make an investment in a risk-free rate, that amount of money is tied up and cannot be invested in instruments that will return a higher rate. This is an opportunity cost as well.
It's crucial for your investments to stay ahead of inflation. If the risk-free rate falls below the rate of inflation, the investment loses value. The opportunity cost in this case is the difference in rates between the inflation rate and the risk-free rate. For instance, suppose a risk-free rate offers a return of 1.5% and inflation is reported to be 2.1%. What is your opportunity costs in this scenario? It is 0.6% which is 2.1% - 1.5%.
Taking Action on Opportunity Costs
As mentioned, some opportunity costs can be quantified, but many can't. Therefore, coming up with steps to measure opportunity costs is not straightforward. What you can do, though, is think about the concept every time you analyze a company. Ask yourself if the company you are analyzing is the best in its industry. If you find others that are stronger, than you have just evaluated the investment in terms of opportunity cost.
It pays to be picky. Don't let the Wall Street hype dictate your investment decisions. Be vigilant and scrap any company that doesn't meet your high standards. If you didn't have high standards before, the time to start is now. Choose the very best companies that have the highest chances of giving you stellar returns and accept nothing less!