3 Easy Steps - What is Opportunity Cost
Newton's Third Law - For every action, there is an equal and opposite reaction.
We're not talking about physics here, but this concept also applies to human actions.
With every decision that we make, there is also a loss of potential gain that we'll inevitably incur merely because of the fact that we decided to go with another option.
Opportunity costs usually remain unseen because it's not tangible. However, as traders or investors, it pays to understand what you're missing out on when you choose to go with another trade. It'll even grant you a stronger understanding of your risk to reward.
With that, here is your 3 step guide to understanding what is opportunity cost and how to overcome them.
#1. Defining opportunity cost
Formally, opportunity cost is defined as the profits lost when one alternative is chosen over another.
Our decision-making process goes a little like this:
A decision is called a decision because we simply can't choose both of them. Hence, when we pick either one, we'll lose the benefits of choosing the other one. Each decision is limited to only having one side of the benefits.
As a trader, the choices that we make are often a little less clear as opposed to other professions.
For instance, we could be taking the trade that has a higher winning % and better risk to reward ratio but end up taking a loss on it. On the contrary, we can also be taking the worse choice and making a tiny profit on it.
Which one really is the better choice?
That's your job, as a trader to find that out.
#2. Understanding opportunity cost
How to calculate opportunity cost?
The idea of working with real numbers instead of estimates is to make it easier for a trader or an investor to measure how much exactly is lost on the forgone alternative.
Imagine a hypothetical scenario where you chose to buy 100 shares of company ABC instead of 100 shares of company XYZ. A year later, company ABC shows a return of 5% while company XYZ is showing 8%.
To calculate this opportunity cost, we'll take the foregone option (8%) and subtract the return on the chosen option (5%), which will give us a 3% opportunity cost.
Logically, but in hindsight, if you see a negative number of opportunity cost, that means that the decision you made is the right one and vice versa.
Explicit opportunity cost
An explicit cost essentially refers to the direct costs of choices made. These are quantifiable numbers that clearly states a value.
The fact that we don't have an unlimited budget or resources is the reason why opportunity cost exists. The more resources we spend on one item, the less we'll get from another.
Not only on the qualitative side, but we need to also learn how to quantify opportunity cost.
For instance, as a trader, quantifying the opportunity cost means comparing the returns of two options. It could be done by forecasting or modelling past history.
Implicit opportunity cost
John is a freelance writer.
He recently took on a project which requires 100 hours from him but pays $1000.
This assignment is due in 10 days.
In taking on this project, he will be sacrificing his time that could have been spent with friends and family and even some peace of mind to work on his personal endeavours.
John could have made this $1000 in other ways as well but it would take a longer time.
Is peace of mind, time to spend with friends and family a larger opportunity cost to John or is it the monetary gain?
Simply put, the implicit opportunity cost is the qualitative loss of opportunity. They are not exactly a direct financial loss but rather the "could haves", "would haves", and "should haves".
The opportunity cost between two choices is and always will be an inverse relationship.
Limitations of opportunity cost
To start with, as humans, we have yet to have the technology that allows us to predict the future.
Don't ask me why, that's just how the universe works.
All that we could do is to grab some data from the past and come up with a model that will give us a positive expectancy, that's all. There is no way of telling that something would happen with 100% accuracy.
The decisions that we, as humans, traders, or investors, are complex. It's almost never apples to apples. Hence the limitation of the ability to take everything into account, including both the explicit and implicit cost.
For instance, you're trying to decide between two investment opportunities. Investment X is slightly more conservative that gives you around 5% returns but only requires you to be invested for 2 years. Investment Y can give you over 10% returns per year but is a little riskier and requires you to be invested for 10 years.
If you choose investment X, your opportunity cost will be the bigger gain over the long term.
If you choose investment Y, your opportunity cost shifts from the quantitative side to the qualitative side. It will revolve around stability and liquidity. By tying up your funds, you're restricted in terms of buying power to invest in other opportunities.
Analysing opportunity cost beforehand doesn't always fit clearly into the equation. Ergo, it's only possible to clearly calculate the opportunity cost after the decisions have been made and the outcomes have transpired.
10 real-life examples of opportunity cost
The concept of opportunity cost applies to every single decision made. So here are a few more examples of where you might be paying opportunity cost.
1. Saving vs investing
By saving money, you're losing out on the money you could have made through investing it. The opportunity cost of holding your money and not doing anything with it also involves inflation.
Check out Marcus's video, where he dives deeper into this topic.
On the other hand, if you choose to invest that money, your opportunity cost might be not being able to use this fund for other purposes such as go on vacation, purchase books, or even buying a gift for a friend.
2. Choosing majors
Assume that a double major doesn't exist and you're forced to choose a major when you reach tertiary education.
It's either finance or journalism.
If you go for finance, you'll lose out on the fun and the skills that you could have had as a journalist.
If you go for journalism, you might lose out on the financial education from the course. It might even cause you to lose out on some monetary gains later on.
3. Paying somebody to do the work
Jim is a consultant who makes $100 per hour at his job. Now, Jim needs his house repainted.
If Jim chooses to pay somebody $50 to complete the paint job in 4 hours, he loses this $50.
The opportunity cost here is that if Jim chooses to paint his house himself for four hours, he'll potentially be losing out on over $400.
4. Choosing an asset to invest in
Deciding to invest is the first step to building and compounding wealth. The next is deciding which asset to invest in. It could range from real estate, stocks, ETFs, bonds, cars, and all the way to Pokémon Cards!
Which asset has a better long term outlook with the least risk?
5. Go on vacation now or use that money to invest in a house?
6. Go to college or start that business now?
7. Go to a party or stay in to work on a side hustle?
8. Should I take a bus and pay the fare or drive?
9. Should Tony buy a pizza for $10 or a hot dog + a drink for the same amount?
10. Should Amanda quit her 9 to 5 and freelance or stay on for stability?
#3. How to account for opportunity cost?
As a trader or an investor, although it's usually not possible, we try our best not to leave any money on the table. Nonetheless, opportunity cost still exists. So here is how to properly consider the opportunity cost of every choice.
1. Keep opportunity cost in mind
According to the University of Massachusetts Dartmouth, one of the most important elements of decision making is weighing the risk to reward of the potential outcome. Especially in the realm of trading.
Ask the question: "What will I lose out on by picking this alternative?"
Then, of course, assess those alternatives and consider which one is more important to your current situation.
2. There is an opportunity cost in waiting
Firstly, remember that not making a decision is also a decision in itself.
And secondly, you're losing out on the potential profits because you couldn't pull the trigger.
That said, it doesn't mean that you should rush into decisions without giving it a second thought, but rather just aware that every minute that you take to make that decision is a minute that could have given you some returns.
No pressure though...
3. Misexpecting the opportunity cost
On one end, there are people who underestimate opportunity cost and end up paying huge amounts of it. And on the other, are those who overestimate opportunity costs.
A study on opportunity cost determined that when the choices are limited to external constraints (such as time or budget), it can cause decision-makers to overestimate the opportunity cost of merely picking one specific option.
To illustrate this, when you're presented with several options, your opportunity cost is not the combined value of everything you didn't choose. Rather, it's only what you gave up when you selected the best choice.
In short, overestimating opportunity costs can cause you to have a skewed view of the situation and result in irrational actions.
4. Opportunity cost vs hindsight bias
As mentioned above, due to the nature of decisions where both the qualitative and quantitative side plays a role, opportunity cost should mainly be used to assess past decisions. And use the outcome of this past decision to guide future decisions.
This is a great practice. However, be aware to not fall into the category of hindsight bias.
Hindsight bias refers to when you view the event as more predictable than they really are.
In simple words, if you made the decision using the information that you had at that time but this decision ended up to be the inferior choice, it doesn't mean that it's a bad decision. Vice versa.
5. Opportunity cost vs trade-off
Trade-offs are all the other alternatives that are foregone to do what we want.
Opportunity costs are the costs of missing out on the next best alternative.
6. Opportunity cost vs sunk-cost bias
Sunk costs are the costs that cannot be recovered.
Opportunity costs reflect the returns that could have been made elsewhere.
7. Opportunity cost vs marginal cost
Marginal costs always have a monetary value (visible).
Opportunity costs can have a monetary value or not.
Conclusion:
Opportunity cost can mean different to each individual and profession. But as traders, we always want to maximise our gains, or if you're an economist, minimise the losses.
Completely understanding this concept is only going to benefit you as it helps you understand what you're foregoing above the monetary value.
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