As an investor, you may be well aware that you have numerous investment options. Each option comes with its own costs and risks as well as its potential returns or rewards. At first glance, you may simply make an apples-to-apples comparison about the different options available to determine the best way to allocate your funds. However, it is important that you have a firm understanding about how to calculate opportunity cost and what this concept is before you make financial decisions.
Understanding Opportunity Cost
If you want to make savvy financial decisions, you must understand how to calculate opportunity cost, but what is opportunity cost? This concept essentially refers to the opportunities that you pass up on because you decided to move forward with another opportunity.
Whether you are comparing two or more opportunities, these opportunities usually are exclusive of each other rather than dependent on each other.
For example, you could buy shares of stock in Company A or in Company B, but you cannot afford to buy shares in both options.
You also could decide to buy a few shares in each company or to hold off and invest your funds at a later date. By doing so, you may get the stock for a better or worse price.
What Types of Opportunity Cost Are There?
Before you learn how to calculate opportunity cost, you should be aware that there are many types of opportunity costs. While this is a straightforward economic or financial concept, it can be applied in differed ways. Some of the more common types of opportunity costs relate to:
1. Other Potential Investment Opportunities
As mentioned previously, you could choose between investing In thousands of stocks, mutual funds, and bonds. You could also invest in real estate, a franchise or another business opportunity.
For each opportunity that you are considering, you must analyze the costs and risks as well as the return. When you want to know how to calculate opportunity cost, all relevant factors should be fully explored.
2. The Opportunity to Spend, Save or Invest
Investing your money is only one option available to consider. You also could consider spending your money or saving it for a rainy day without making an investment purchase.
By spending it, the money becomes unavailable for future purchases. By saving it, you are not acting on a current investment opportunity, but the money is not lost. You can always invest it or spend it at a later date.
3. The Opportunity to Diversify Your Portfolio
Another option available is to diversify your portfolio. The opportunity cost associated with adding yet another stock to your portfolio is that your portfolio becomes overly heavy with riskier investments. Perhaps you are even loaded with tech stocks, and you are not well-diversified in different asset classes.
Proper diversification of your portfolio across different asset types and asset classes can help you to generate a better return. This can also help you to mitigate risk over time.
How to Calculate Opportunity Cost
Now that you are more aware of the different types of opportunity costs available, you may be wondering how to calculate opportunity cost. The first step to take when you want to know how to calculate opportunity cost is to estimate the return of each investment opportunity available.
Then, you will need to determine which opportunity presents the greatest possible return. Your opportunity cost is calculated when you subtract the return of the selected option from the return of the option with the greatest return.
For example, you have the opportunity to purchase stock or to re-invest in your company. The return on investment for a specific stock that you are thinking about buying is 13%.
This is while the reinvestment of funds into your company has an expected return of 10%. Therefore, the opportunity cost if you choose to reinvest in your company is 3%.
You should be aware that it may be impossible to accurately determine opportunity cost until after the fact. Opportunity cost is calculated based on projected or estimated figures.
There are many factors that can influence the overall rate of return that you enjoy from a specific investment. Therefore, many of these factors you cannot control.
You should, however, do your best to determine a reasonable return for each investment that you are considering so that you can determine a more accurate opportunity cost.
Applications of Opportunity Cost
For every dollar that you have access to, you have many opportunity cost scenarios to consider. You may make opportunity cost analyses numerous times per day without realizing what you are doing. On the other hand, it may help you to make these calculations if you are not currently doing so.
1. Making a Purchase
One of the most common applications for determining opportunity cost relates to making a purchase. When you make a purchase, you may decide between buying junk food or healthy food at the grocery store. Or between buying a home or renting an apartment and more.
You can see that each financial decision you make can affect your finances as well as your lifestyle, health and many other factors. While it may be wise to make smart financial decisions, it is also wise to make periodic purchases that improve your lifestyle and that make you happy.
Finding a balance between these factors is important.
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2. Making an Investment
You may also be trying to decide whether you should make an investment and what type of investment to make. Your options may be limited by your investment amount.
For example, you may not have enough money to invest in a large apartment building, but you may be able to buy a small franchise or to buy a small rental home.
When you make an investment, you should carefully understand how your investment decision affects your return. You should also consider future investment opportunities, risk and other important factors.
3. Paying Off Debts
You also have the opportunity to pay off debts with your funds. However, you need to decide if you will pay off your credit cards, student loans, car loans or mortgage first.
One strategy may be to pay off the highest interest rate credit cards first, and you may follow this by paying off other unsecured debts. Then, you may move on to pay off balances on secured loans that have a lower interest rate.
How you allocate funds can affect how quickly you pay off debts. This is because paying off higher interest rate loans first means that you will minimize interest charges over time.
Understanding what opportunity cost is and how you can use it is important if you want to make savvy financial decisions. This is a concept that you can use in both your personal and business decision-making processes. Each time you decide to spend, save or invest money, you must analyze opportunity costs. More than that, you should understand that there are costs associated with inaction as well. When you understand all aspects of opportunity costs, you can make a more educated decision about how to allocate your funds in different ways.