When you make any decision, you probably weigh its pros and cons. The same is true for purchases and investments. Before you decide which option to choose, you think about what you will gain and what you will lose. This is the easiest way for most people to think about opportunity cost. Simply put, the opportunity cost is the benefits and losses that are associated with a purchase or investment. Let’s break down how to calculate opportunity cost, starting with step one.
Step One: Learn the Right Formula
Sacrifice Divided by Gains Equals Opportunity Cost
It might seem strange, but there is no specific formula to calculate opportunity cost. This is because the opportunity cost boils down to the value of the “next best option.” This value might not be monetary or only partially monetary. For financial investment decisions, one of these values might be time. Higher risk investments have the potential for greater gain in less time.
You might wonder how to calculate opportunity cost in these situations. The answer? Use a ratio. The formula is not “gains minus sacrifices.” Instead, think of it as “sacrifices divided by gains.” The ratio will give you a more accurate idea of what you are giving up to make your decision.
An Opportunity Cost Example: Choosing a Job
For example, consider how you look at available jobs. Perhaps there is a position available in retail and a custodial position. The retail position pays $15/hr and the custodial position pays $30/hr. It is tempting to simply conclude that the opportunity cost of taking the retail job is $15/hr, because that is the pay difference.
However, using the ratio of sacrifices (custodial pay) divided by gains (retail pay), you get $2 of opportunity cost. The opportunity cost tells you that for each dollar you earn working in retail, you have sacrificed $2 working as a custodian.
The difference is subtle in this example. It will be important as you compare more complex decisions to use the ratio rather than subtraction. Let’s take a look at how to apply this formula to investments.
Step Two: Apply the Formula to Investments
To make sound investment decisions, it is important to thoroughly compare your options. Opportunity cost is one way to make these comparisons. Rather than overwhelm yourself or miss an important factor in comparison, use the ratio to keep things straightforward. You can compare the options by each value or aspect, then use those comparisons to make a decision.
For example, if you have $50 to invest, you may be choosing between stocks and bonds. Let’s take a look at how to calculate opportunity cost and compare these options.
One of the main focuses of all investing, monetary gain, should always be considered. Stocks potentially increase by large proportions. Bonds, on the other hand, usually increase in value at a fixed rate. The return rate is the rate of monetary growth. To compare stocks and bonds, you can use the return rates to calculate opportunity cost.
Imagine Stock A has shown year-over-year increases of between 4% and 8% for the past five years. Take the average and give it a return rate of 6%. The bond you are considering is Bond Z, which has a guaranteed return rate of 2% per year. Using the formula, you find an opportunity cost of 3%. This tells you that when you invest in Bond Z, for every 1% gained, you miss out on 3% Stock A would have gained.
Potential Monetary Loss
Stocks come with the risk of monetary loss. Bonds, on the other hand, do not come with that risk. Instead, the opportunity cost becomes the hypothetical dramatic gains that the stocks could have given you. Like the previous category, let’s compare Stock A and Bond Z. In the previous section, we assumed that Stock A would continue to perform comparably to the past five years. However, the stock can lose some or all of its value. In this case, its return rate would be negative.
While you cannot calculate the exact opportunity cost because you can’t predict the future, take opportunity cost into account when you make your decision. If you value guaranteed monetary gain, you should purchase bonds over stocks.
Another way to minimize the risk of monetary loss is to diversify your investments. Perhaps you could accept a loss of $25, so you invest half of your $50 in Stock A and the other half in Bond Z.
Stocks can return higher rewards in less time than bonds. Bond Z is a five-year bond, which means you only receive the full 2% per year gains if you cash it in after five years have passed. Stock A, on the other hand, can be purchased or sold at any time.
If you have a goal to reach, you can compare investments in terms of how long it would take to reach that goal. Let’s look again at Stock A and Bond Z. Stock A has a return rate three times higher than Bond Z. This means that you would reach your goal in one-third of the time.
If your goal can be reached in three years at Stock A’s 6% return rate, then choosing Bond Z has an opportunity cost of 3/5. An opportunity cost of less than one indicates that you are choosing an option with a larger sacrifice than the alternative. In this example, this is because Bond Z takes more time than Stock A to achieve your goal.
An opportunity cost of less than one doesn’t always mean you should make a different decision. In this example, time is just one factor in the decision you are making.
Final Thoughts: How to Calculate Opportunity Cost
While there is no way to guarantee you are making the right financial decision, calculating the opportunity cost of your various options is a good start. Use this process to make logical comparisons between complex options. Now that you know how to calculate opportunity cost using the ratio formula, you can be sure you are making accurate comparisons.