Partners calculating opportunity costs of an investment.

What Is An Opportunity Cost And How Can You Calculate Its Value?

Molly Grace7-Minute Read
August 31, 2021

You’re walking through a magical forest when you come to a fork in the road. Down one path is untold riches; if you take this path, you’ll never want for anything in your life. The other path promises you unrivaled magical abilities; walking this path will make you powerful enough to rule the world.

Which way do you go?

Believe it or not, the question of which path you should take is, at its core, an economic question. It’s a question of opportunity cost.

On a less fantastical scale, we make these kinds of decisions every day throughout our lives – going to the gym instead of going out with friends, saving for vacation instead of purchasing concert tickets, choosing one college major over another. Opportunity cost is what we give up when we make these decisions.

But why should you care? Understanding opportunity cost can help you make better, more conscious decisions about your finances – and your life.

What Is Opportunity Cost?

Opportunity cost is an economic principle that helps us understand what we’re giving up when we choose one option over another. Opportunity cost is the value of the option you didn’t choose.

In terms of investing, it translates to: if I choose to put my money into Investment A, how much will I earn in interest compared to if I’d put my money into Investment B? However, it can be applied to a lot of different scenarios, including ones where money isn’t directly involved.

How Does Opportunity Cost Work?

Because none of us have unlimited time or money to do all the things we want with our lives, we’re constantly making tradeoffs that we think will bring us the most desirable outcomes. Enjoying one activity means you won’t have that time to enjoy something else. Spending money on one item means you won’t be able to spend that money on anything else. When you make a choice, you’re always giving something else up.

If you want to get ice cream but only have enough money in your pocket for a single scoop, you have to decide which flavor would bring you the most joy. When you end up buying a scoop of rocky road, your opportunity cost is the happiness you would’ve experienced eating pistachio ice cream.

Scarcity

The concept of opportunity cost ties right in with the concept of scarcity.

What is scarcity? Basically, we have all these wants and needs, but only so many hours in the day and so many dollars in our bank accounts to satisfy those wants and needs. Taking opportunity cost into account when we make decisions can help us make the most of our limited, or scarce, resources.

Is Opportunity Cost An Actual Cost?

It’s important to understand that opportunity cost isn’t an actual cost in the sense that you’ll pay for it out of pocket or budget for it. It’s a concept that attempts to quantify what you give up when you choose one option over another.

Imagine you own a bakery. To keep your business running, you have certain costs that come out of your budget. These are things you physically pay for: employee salaries, rent for the building your bakery is in and supplies like sugar, butter and flour to continue making your baked goods. These types of costs are referred to as explicit costs. They’re the cost of doing business.

Now imagine you’re deciding between two different baked goods to add to your menu. One is a fancy type of cookie that’s particularly hip right now. You know you’d sell a lot of them, but they’re expensive and time-consuming to make. Instead, you choose to make a cupcake that’s less popular, but requires fewer resources to make.

In this scenario, your opportunity cost is the potential profit you lost out on by choosing not to make the more popular cookie. It’s not something that shows up in your budget, but rather potential profit you lost out on.

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How Do You Calculate Opportunity Cost In Financial Decision-Making?

To understand your opportunity cost for things like investments, you’ll need to determine the difference between what you gain and what you give up when you choose one option over another.

Say you have $10,000 to invest in the stock market. Investment A has a projected rate of return of 7% while Investment B is projected to see a 12% rate of return.

Based on these projections, you’d be forfeiting 5% in returns by choosing Investment A over Investment B:

12% - 7% = 5%

Over the course of 5 years, if you chose Investment B, you’d have a little over $17,600. In that same time span, Investment A would have you at a little over $14,000. Because you picked Investment A, you missed out on around $3,600.

$17,600 - $14,000 = $3,600

Investment B seems like the obvious choice, right? Not so fast. While it does have higher projected rate of return, this investment also has a higher risk. So while you may see a 12% return on Investment B, you could also end up losing money if the projected return rate is wrong. This is where opportunity cost and risk tolerance intersect.

How Are Risk Tolerance And Opportunity Cost Related?

Your level of risk tolerance refers to how much risk you’re willing to take on when investing. Investments with the highest potential returns also tend to be the riskiest, while investments with lower expected returns tend to be less volatile.

Investors with a high level of risk tolerance are more likely to utilize an aggressive investing strategy, where they have the potential to gain a lot of money but also risk losing a lot of money. Investors with a low tolerance for risk typically take a more conservative investment strategy, putting their money in investments that are reliable and stable but typically see lower returns. These investors might not earn as much as more aggressive investors, but they’re also less likely to lose money in their investments.

How does this relate to opportunity cost? With many decisions, including investment decisions, your actual opportunity cost is only obvious in retrospect. You can’t know for certain if one investment will perform better than another, or if one decision will be more beneficial than its alternative.

Consider the risk and potential opportunity cost of telling your crush that you like them. You could tell them, but you risk feeling embarrassed if it turns out they don’t like you back. On the other hand, if you decide not to tell them, you potentially miss out on having a relationship with someone you really like.

In this scenario, your opportunity cost of not telling them is the potential relationship you could’ve had. However, you don’t know for certain that this is a cost you’d actually be missing out on – it’s just an educated guess.

Opportunity cost can’t tell you what to do or how to feel about the risk you’d be taking. You’ll have to decide for yourself whether the potential benefit of telling them is worth the risk of rejection.

Opportunity Cost Example: Going To College

Still a little confused about how all this is relevant to you? To see how opportunity cost plays out in real life, let’s look at a more in-depth example. In this one, imagine you’re considering attending college, and are wondering what the opportunity cost of that might be.

Having a college degree can help boost your future earnings, meaning you may earn more income over the course of your life if you go to college than if you don’t. However, if you’re going to school full time, you typically can’t also work full time. The income you would have earned working full time is an opportunity cost of attending college full time.

Say, for example, you spend $80,000 total to attend school and get a 4-year degree. During that time, you could have instead worked full time and earned $22,000 per year, or $88,000 over 4 years. When all is said and done, not only will you have spent $80,000, you’ll also have given up an additional $88,000 in potential income. That’s your opportunity cost, at least in the short term.

However, this doesn’t give us the full picture. Maybe, for example, you’re getting a degree in a high-paying industry that requires workers to have bachelor’s degrees. As soon as you graduate, you’re offered a job with a salary of $75,000. If you stay in this job until you retire in 40 years (and don’t receive any raises or bonuses), you’ll have earned around $3 million total.

Compare this with your earnings if you worked your $22,000 per year job for 44 years (this includes the 4 years you gained by not going to school) – over that time, you’ll have earned a little less than $970,000.

Even though you’re initially spending money to attend school and forfeiting the income you would’ve earned if you weren’t in school, you’ll more than make up for it over the course of your working life.

The Bottom Line: Opportunity Cost Can Be A Useful Tool To Help You Make Decisions

The main takeaway here is that you can utilize opportunity cost to help you make better financial, personal and business decisions. But opportunity cost isn’t a magic crystal ball, and it can’t always tell you whether what you’re giving up is worth what you gain. You’ll still have to make decisions based not only on what makes financial sense, but also on what suits your needs, wants and desires.

Think about the decision to go on vacation. It rarely makes sense from a purely financial perspective – after all, you’re paying money for an experience that will quickly be over, when you could instead invest that money or save for a big financial goal. And if you don’t get paid time off from work, you’ll also be forfeiting the wages you would’ve earned if you’d been working.

But, as anyone who’s enjoyed a nice trip will tell you, vacation comes with all sorts of benefits that don’t come with a dollar value: much-needed R&R, family bonding, enriching new experiences and decreased stress.

Opportunity cost is a useful tool, but only you can answer that all-important question: Is it worth it?

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Molly Grace

Molly Grace is a staff writer focusing on mortgages, personal finance and homeownership. She has a B.A. in journalism from Indiana University. You can follow her on Twitter @themollygrace.