October 14, 2015 in Investing

What is opportunity cost and why should you care?

When you buy a salad but really want a sandwich, there are 2 costs. The 1st is the direct, actual cost of the salad. The 2nd, unseen, price is the opportunity cost; in this case, the lost value of a sandwich to your tummy.

“Basically, an opportunity cost is the value of the next-best choice,” says Phillip Christenson, CFA, financial planner and portfolio manager at Phillip James Financial in Plymouth, Minnesota.

Opportunity costs are not limited to economic decisions. Time is also a finite resource often squandered. Though pleasure lost in time wasted is hard to measure, opportunity costs in the financial realm are solidly quantifiable.

What is opportunity cost?

A great example of opportunity cost in action is choosing between paying down debt or investing, says CFP professional Jonathan Duong, CFA, founder and president of Wealth Engineers in Denver.

“When you make a decision and commit to something, you’re by definition, in terms of money or resources, forgoing another opportunity,” he says.

In the example of investing versus paying off debt, an investment‘s rate of return compared with the rate of interest paid on debt makes measuring the trade-off fairly straightforward.

But there may be other considerations. For instance, risk and taxes can complicate the picture.

How do I factor this into my investing plan?

Allocating your investment portfolio among asset classes such as stocks and bonds also involves opportunity costs.

“From a portfolio perspective, there may be investments you would like to have in your portfolio, but you only have so much money. You can invest in bonds and money will grow, but it won’t grow as much as in stocks,” says Christenson.

Stocks historically have served up higher returns but with increased volatility. Bonds provide regular income but carry their own risks, such as falling in value when interest rates rise. Also, rising inflation can eat into purchasing power for bond investors.

A risk-averse investor may be tempted to invest only in fixed-income investments as a safety measure, but there may be a high opportunity cost associated with forgoing stocks. For instance, there is a heightened risk that such investors will fall short of their long-term goals without the extra boost from the stock market.

“Without doing some calculations, you’re making an important decision with no basis for doing that. When you’re considering taxes and risk, it’s critically important to do some analysis to support your decisions,” Duong says.

Opportunity costs can be anything

If people ran their personal finances like a good business, each dollar would be put to its most efficient use.

“The goal of every manager, financial or operational, is the effective and efficient allocation of scarce resources. Because resources are scarce, managers must determine the best way to use them among a multitude of competing opportunities,” says Robert Stammers, director of investor education at the CFA Institute.

“With any decision, there are the actual value of resources and the cost to employ them, and there are the opportunity costs, which, in short, are the benefits forgone that one could have received by taking alternative actions,” he says.

Though individuals want to use their scarce resources, such as dollars, efficiently, the slippery concept of happiness gets in the way of accumulating wealth.

Dollars are worth trading for comfort and enjoyment. But dollars are also necessary for saving and investing. Individuals have to answer the question for themselves: Which opportunity costs are worth paying?