Understanding Opportunity cost and its usefulness in investing: What factors do you consider before you take any decision that involves money? These factors could include affordability, returns, usefulness, pros, and cons, etc. But have you ever considered that simply not choosing an option too has a cost associated with it?
Today we take up an aspect of economics that is generally overlooked when it comes to decision making i.e. Opportunity Cost. We also try and find out its relevance in investing.
What is Opportunity Cost?
In microeconomic theory, opportunity cost or alternative cost is the loss of potential gain from other alternatives when one particular alternative is chosen over the others.
In simpler terms, it refers to the potential benefit that a person misses out on when they choose one alternative over the other. The objective of opportunity cost is to ensure the efficient usage of scarce resources. It exists even when you make no choice at all. It also uncovers the loss of not making a decision.
Opportunity cost is generally unseen and can be easily overlooked as they are not accounted for in the financial statements. However, management or Investors use this concept regularly while making decisions that involve multiple options.
In reality, the opportunity cost theory is a very important concept. This applies not only to investors and businesses but also to individuals in their personal life.
Real-life Examples of Opportunity cost
Let us take an example that includes one of our peers. He/She has decided to pursue an MBA worth Rs. 20 Lakhs (Tuition plus boarding and dining cost) for two years. She came to this decision after receiving a government scholarship of Rs. 5 Lakh. How much cost do you think she will be paying for if she actually goes through with it?
Most of us would have already arrived at the conclusion that she will be liable to pay a cost of Rs. 15 Lac. The true cost here is 15 Lakh (as she has also earned her scholarship) plus the income he/she will have to forego by attending an MBA college. If your peer would have earned Rs. 6 Lac/year (ignoring hikes or bonuses received in this period) by working then the true cost would amount to Rs. 27 Lakh.
Many of us would ignore the opportunity cost of the peer losing out on potential income. In order to arrive at an educated decision, the peer would have to compare the cost of education plus the forgone income vs. the benefits she would receive after receiving an MBA.
How to calculate the opportunity cost?
We calculate the opportunity cost by comparing the returns of two options. The following formula illustrates an opportunity cost calculation.
Opportunity Cost = Return of Most Lucrative Option – Return of Chosen Option.
Take for example you are provided with the option of investing Rs. 1 Lakh. You are thinking of investing in a Blue Chip Mutual fund that provides a 10% return. You also have the option to invest in a Small Cap Fund that could provide a 20% return.
Here, by applying the formula above we would arrive at:
Opportunity Cost = 20,000- 10,000 => 10,000.
The Ratio of Opportunity Cost
We can also use the ratio of opportunity cost. This uses proportions to demonstrate the value of each choice. This is done by illustrating what has been sacrificed against what’s been gained from the alternative.
Opportunity cost = What you sacrifice by making the choice / What you gain by making the choice
Taking the same example used earlier where we invest in a Blue Chip mutual fund as Small Cap funds are risky.
The Opportunity Cost is = 20,000/10,000 => 2/1 = 2.
Opportunity Cost and Investing
Investing is all about parking money in a financial product with the hopes of making more money than what was invested. Everyday investors are faced with options where they have to decide how to invest their money in order to receive the highest or safest return. While they take the decision they usually factor in returns, the risk involved in making that decision but often leave out opportunity cost.
Opportunity Cost takes into consideration that you could miss out on a great opportunity in the future because you have committed your money to another investment. It makes it easier for us to prioritize one decision over others by putting numbers to these decisions. This results in a better data-driven method that prioritizes where our money is spent.
Opportunity cost can also be used within a company or by an individual when they decide where to raise money from. This could be through equity or through debt
The following are some of the reasons why opportunity cost helps us take better decisions apart from what has been already discussed
1. Helps us realize the cost of doing nothing.
Individuals at times are led to believe that there is no cost incurred when money is left idle. This leads them to simply keep money in a safe etc.
Opportunity cost takes into consideration the potential income the money could if invested in fixed deposits, bonds, mutual funds. This helps individuals take into account the difference their funds could make if they invest it in a financial instrument.
2. Helps take into account the cost of not disinvesting.
This often happens when an investor is too emotionally invested in a stock or has not adhered to an already set stop loss. In a situation where an investor remains locked in on a stock whose price continues to decrease he is risking not only the possibility of the stock plunging further but also the possibility of salvaging some return by investing in other safer instruments.
It is important to note that disinvestment is also an investment decision and opportunity cost helps quantify this decision by taking into consideration alternative investments.
3. Helps put into perspective the cost of not borrowing
Taking on debt is generally viewed in a negative light but this does not always have to be so. Take an example that a small company has the option to take advantage of diversifying into the new industry due to its profitability. Opportunity cost then helps the management put things into perspective if the investment can be financed and still come out profitable through debt.
Although Opportunity Cost provides the possibility of earning higher returns we should always remember that it involves looking forward into the future. This can be combated by first setting our investment objectives. Then opportunity cost could be used to help navigate the options that fit within the risk class of those objectives.
If we let our investment objectives be affected by opportunity cost then there is always going to be an investment opportunity that has the possibility of providing higher returns. The beauty of opportunity cost lies in the fact that it can be used by all. These could also be situations that are not financial.
Aron, Bachelors in Commerce from Mangalore University, entered the world of Equity research to explore his interests in financial markets. Outside of work, you can catch him binging on a show, supporting RCB, and dreaming of visiting Kasol soon. He also believes that eating kid’s ice-cream is the best way to teach them taxes.