How to Calculate Opportunity Cost: Formula and Definition

Key Takeaways

• Pursuing an investment strategy without first factoring in the benefits of options could cause the investor to miss out on even better outcomes.

• When deciding between a traditional and alternative investment, it is helpful to determine expected returns. However, other variables are often factored in.

• Because opportunity costs do not show up on balance sheets or other external financial reports, and are invisible by definition, they are sometimes overlooked.

When making investment decisions, it is vitally important to understand the opportunities prospectively missed when making one choice over at least one other. The analysis used in this regard is called opportunity cost, which can help tremendously with investment strategy. With that said, here is how to calculate opportunity cost: formula and definition.

What is Opportunity Cost?

In truth, nearly everyone engages in opportunity costs on a regular basis. Such costs are the potential missed opportunities resulting from opting for one thing over another. A prime example is when making everyday purchases. Because one obviously cannot buy everything, decisions must be made regarding what to buy – over other things.

Because opportunity costs do not show up on balance sheets or other external financial reports, and are invisible by definition, they are sometimes overlooked. But in investing – which is the focus here – calculating the opportunity cost of investment options can markedly help with decision making. After all, such an analysis involves weighing the costs and benefits of all options.

For example, say the parents of an 18-year-old investor advised him to unfailingly put all his disposable income into bonds. Over the next half century, the investor did, in fact, dutifully invest $5,000 annually in bonds, gaining an average yearly return of 2.50 percent. He retired with a half-million dollars in holdings.

While this is a generally impressive result, it is mostly viewed as such in isolation. In fact, the result may look differently if one considers the investor’s opportunity cost. What if, for example, the investor had invested half their capital in an asset that received a 5 percent average blended return? Their holdings would have been worth north of $1 million.

In another example, say a business invests a certain amount of money annually in the stock market or reinvests it in the company. The assumption is that its return on investment from the stock market investment will surpass 16 percent over the next year. Another expectation is that, over the same period, reinvestment in the business through the purchase of new equipment will produce a 13 percent return on investment. Here, then, the opportunity cost is 16 percent minus 13 percent, or 3 percent.

Also, consider an investor who decides to invest $100 in General Motors Corp. Their opportunity cost is the potential returns that $100 could have produced had the investment gone to a different stock, such as Ford Motor Co. or Toyota.

How to Interpret Opportunity Cost for Investing

When determining opportunity costs, more than just flat returns should be considered. Further, investors should also factor in risk levels involved in their choices. More on that later.

Ultimately, opportunity costs can simply be viewed as a trade-off. Thus, if one chooses to put capital in government bonds or, say, art instead of high-risk stocks, their decision requires a trade-off. What opportunity cost seeks to do is assign a figure to that trade-off. The question for the investor then becomes, which trade off can they live with?

For example, if one uses capital for loan payments, that money is tied up and is unavailable to be invested. Because of that, the investor may be missing out on gains from investments such as stocks, bonds, or alternatives. The trade-off here is determining whether leveraging debt will ultimately be more profitable than investing capital.

Also, opportunity cost can affect financial decisions. Day traders or those investing in the stock market over the long term must decide, for example, how much cash to keep around. This is particularly true during times of economic uncertainty and a bear market when the proclivity is to keep more cash on hand for unexpected situations.

What are the Types of Opportunity Cost?

There are two types of opportunity cost:

• Implicit opportunity cost. This is an intangible cost that cannot be easily accounted for, and thus is harder to calculate. Say a company invests a substantial amount of time into its nonprofit efforts. The implicit cost, then, is the money earned – rather, lost – by volunteering instead of working.
• Explicit opportunity cost. These typically are costs that can be counted, such as tangible costs or a dollar amount. For example, a company may spend $2,000 from assets for new printers for employees. The explicit cost, then, is how else the company could have used the $2,000, and what it might have forgone by spending the money on printers.

How to Calculate Opportunity Cost

When it comes to how to calculate opportunity cost, there is no formal set formula for determining opportunity cost. However, the simplest and most relevant one for investors is C = FO – CO

where:

FO = Return on best forgone option
CO = Return on chosen option

Any way it is calculated or looked at, opportunity cost is still basically the value an individual or entity must forgo when an option is chosen over another potentially viable option.

Real-World Example of Opportunity Cost Involving a Traditional and Alternative Investment

Alternative investments are assets that do not fit into traditional categories of cash, income, and equity. Examples include real estate, venture capital, art, and commodities. They are increasingly popular as ways to earn passive income.

When deciding between a traditional and alternative investment, it is helpful to determine expected returns. However, other variables are often factored in. Say an individual has an opportunity to invest $5,000 in an exchange-traded fund with an expected per-annum return of 15 percent. They also have the option to put the same capital in a commercial real estate investment that promises just a 10 percent return. Because as an asset, real estate can help diversify one’s portfolio, potentially reduce overall risk and volatility, and protect against inflation, the investor went with real estate.

Opportunity cost = 15 percent – 10 percent

Opportunity cost = 5 percent

Simply put, by investing in real estate instead of an ETF, the investor forgoes the opportunity for a higher return, although the rate of return of alternative investments is often higher than that of some traditional investment classes. In fact, the overall market for alternative investments is forecast to swell to $14 trillion by the year’s end.

Opportunity Cost vs. Sunk Cost

Sunk costs, which do appear on financial statements, refers to money already spent and will not be recovered. That is the opposite of opportunity cost – potential investment returns given up because the capital was placed elsewhere.

Because sunk costs have already happened, the cost will stay the same regardless of a decision’s outcome. Thus, such costs should not be factored into investment decisions. For example, perhaps an investor put capital in Company A but did not realize gains. The money invested is a sunk cost that cannot be recovered, rendering it irrelevant in investment decision-making.

In another example, if one buys 1,000 shares of Company X at $10 each, the sunk cost is $10,000. Retrieving that money would necessitate liquidating stock. The opportunity cost, though, poses the question: where could that $10,000 have been put to better use?

Opportunity Cost and Risk

In investing, risk refers to the possibility that the actual and projected returns of an investment are not the same, and that the investor loses some, if not all, of the invested principal. Opportunity cost has to do with the possibility that a chosen investment’s returns are less than those of a forgone investment.

The primary difference is that opportunity cost compares an investment’s actual performance against that of another investment. Meanwhile, risk compares an investment’s actual performance against the same investment’s projected performance.

This underscores the need to base investment decisions on more than opportunity cost dollar amounts when sizing up options.

Why is Opportunity Cost Important for Investors to Use?

Opportunity costs are important to investors because they are always looking for the best investment options. In other words, whenever an investor purchases assets, they tacitly chose to not buy others.

Note that a potential drawback of opportunity cost is that it is highly dependent upon assumptions and estimates. In other words, there is no guarantee that projections will play out as anticipated. Variables can, and do, change.

Having said that, pursuing an investment strategy without first factoring in the benefits of options could cause the investor to miss out on even better outcomes. Investors would do well to use opportunity cost as a factor in making investment decisions, whether they are about traditional or alternative assets, or the best way to diversify.

Carefully crafted portfolios generally keep investors from having to consider every investment opportunity, and instead have them consider how much of each asset class an investor should hold.

Alternative Investments and Portfolio Diversification

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments. This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

Investing is all about decisions, and most investors can use all the help they can get. Knowing what opportunity cost is, and how to calculate and interpret it, can help investors choose the best option for them. By using opportunity cost to construct holdings strategically, investors can mitigate volatility as well as the uncertainty of returns.

All securities involve risk and may result in significant losses. Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.