What Is Opportunity Cost?

Opportunity cost is the amount of potential profit an investor loses by committing to one investment option over another. Consider, for example, the choice between selling stocks now or holding them to sell later.

While it is true that an investor can secure any immediate profit that he may obtain by selling immediately, he loses any profit that the investment may bring in the future.

Learn more about opportunity cost and how you can use the concept to help you make investment decisions.

What is the opportunity cost?

Opportunity cost is the value of what you lose by choosing between two or more options. When you decide, you feel that the choice you made will work best for you, regardless of what you lose by making it. As an investor, opportunity cost means that your investment options will always have immediate and future gains or losses.

While opportunity cost is not an exact measure, one way to quantify this cost may be to estimate the future value that you chose not to receive and compare it to the value of the decision you made.

Comparing these measures in hindsight will make them seem more concrete, but keep in mind that such an estimate is only a theoretical difference.

At a basic level, this is a common sense concept that economists and investors like to explore. For example, what if Walt Disney had never started animating?

He may have done something equally successful, or you may have never heard his name. Opportunity cost is the proverbial fork in the road, with dollar signs on each road; the key is that there is something to be gained and lost in every direction. You make an informed decision, estimating the losses for each decision.

Alternative definition: opportunity cost is the loss you assume for a gain, or the loss of a gain for another gain.

How Opportunity Cost Works

When faced with a financial decision, you try to determine the return you will get from each option. For example, you might be thinking of selling one security and using the money earned to buy another.

What does this mean for individual investors?

If you have trouble understanding the premise, remember that opportunity cost is inextricably linked to the notion that almost every decision requires tradeoff. We live in a finite world, you cannot be in two places at the same time.

Explicit costs

For investors, explicit costs are out-of-pocket payments, such as buying a stock, an option, or spending money to improve a rental property. The costs can also be salaries, utilities, materials, or rent.

For example, if you own a restaurant and add a new item to the menu that requires $ 30 in labor, ingredients, electricity, and water, your explicit cost is $ 30.

Your opportunity cost is what you could have made with that $ 30 if you hadn't decided to add the new item to the menu. You could have given that $ 30 to a charity, spent it on clothes for yourself, or put it in your retirement fund and let it earn you interest.

Explicit and implicit costs can be viewed as direct costs (explicit) and costs of using the assets you own (implicit).

Implicit costs

Implicit costs do not represent a financial payment. They are not a direct cost to you, but a lost opportunity to generate income through your resources.

If you have a second home that you use as a vacation home, for example, the implied cost is the rental income you could have generated if you rented it and received monthly rental checks when you weren't using it.

It costs nothing to use the vacation home on your own, but you are giving up the opportunity to earn income from the property if you decide not to rent it.

We hope you enjoy watching this video about What is Opportunity Cost

Source: Marginal Revolution University

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