Opportunity Cost: The Hidden Price of Choice
"To choose or not to choose, that is the question. For in every decision, lies the weight of opportunity cost." Shakespeare might not have been thinking about economics when he penned those famous words, but he inadvertently captured the essence of a fundamental concept: opportunity cost. Today, we face a multitude of choices, from what to eat for breakfast to which career path to pursue. Each decision comes with a nagging feeling that we're missing out on something else—something potentially amazing.
Opportunity cost is more than just an economic term. It's about understanding that every choice has a ripple effect, impacting not just your wallet but your happiness and fulfillment. To put it simply, economics exists because our unlimited wants can't be satisfied by our limited resources. That’s why choices have to be made to allocate resources effectively. Take Starbucks, for example. Their menu is full of beverages, but you can only choose one. Whether it's based on personal preference or cost, the drink you select is the one you value the most. The value of the next best option you didn't choose—that latte you passed up for a cappuccino—is what we call the opportunity cost, the value of what could have been if you had chosen differently.
As we make these everyday choices, it's worth noting that opportunity cost also plays a big role in more complex financial decisions. When it comes to investing, understanding opportunity cost is key. Investors constantly face a crucial decision: how to allocate investments across stocks, bonds, ETFs etc. Each option has its pros and cons, but trying to invest in all of them would be overwhelming, so you need to prioritize. The question is: do you prioritize the possibility of higher capital gains from stocks or the reliability of regular interest from bonds? Or perhaps you prefer the diversification and flexibility offered by ETFs? If you decide to invest in stocks, the interest you could have earned from bonds or the returns from a bond ETF become your opportunity cost—the value of what you gave up by choosing stocks over these alternatives.
Calculating opportunity cost is straightforward. Start by clearly defining the decision you're making and listing all viable alternatives. Using the example above, you would identify your main options as stocks, bonds, and ETFs. Next, determine the expected return for each alternative. Let's say stocks are expected to yield a 10% return, bonds offer a 5% return, and a bond ETF provides a similar return to bonds but with added liquidity and diversification benefits. Once you've chosen an option—let's say you choose stocks—the best alternative is bonds or a bond ETF. Now, you calculate the opportunity cost by comparing the returns of the two options. The opportunity cost is essentially the return you could have earned from the alternative you didn't choose. In this case, if you choose stocks over bonds or a bond ETF, the opportunity cost is the 5% return you could have earned from these alternatives. This means that by choosing stocks, you are giving up the opportunity to earn a steady 5% return from bonds or a bond ETF.
But here's the thing: opportunity cost isn't just about money. Sometimes, the best choice doesn't bring in the most cash, but it gives you something priceless—like happiness, love, or the satisfaction of finally mastering that tricky recipe. Here’s an example: consider someone who chooses to pursue a career in the arts instead of a more lucrative field like finance. While the financial returns might be lower, the intangible benefits of personal fulfillment and happiness can be invaluable. Decisions like this can often be driven by a desire for a sense of purpose and satisfaction that goes beyond monetary compensation.
As we consider these non-monetary benefits, it's also important to recognize how our decision-making processes can be influenced by various biases in behavioural economics. One of them is opportunity cost neglect, which is the tendency to overlook or undervalue the potential benefits of alternative options when making decisions. This can lead to suboptimal decision-making by causing individuals to focus primarily on the immediate costs and benefits of a single option, without fully considering the potential value of forgone alternatives. Another significant bias is the sunk cost fallacy, which occurs when individuals or organizations base their decisions on past investments rather than considering present circumstances and future benefits. A business may continue to invest in a failing project because of the significant resources already dedicated to it, ignoring the opportunity to allocate future resources more effectively elsewhere. Loss aversion also significantly impacts decision-making related to opportunity cost. It causes us to fear losses more than we value gains, leading to overly cautious behavior and missed opportunities. For example, the fear of temporarily losing money in the stock market might prompt us to sell at a 5% loss, preventing us from holding on until the stock potentially recovers and reaches new highs.
Understanding these biases is crucial for making sound decisions, but it's equally important to remember that opportunity cost is a concept that applies broadly across our lives. It helps you prioritise what matters and get the most out of every decision. Whether choosing stocks or a Netflix show, you're weighing options based on opportunity cost. So, when you're making decisions, remember that opportunity cost is like that friend who always asks, "What else could you be doing with your time and money?".
Sources:
https://www.thebehavioralscientist.com/glossary/opportunity-cost-neglect
https://www.wallstreetprep.com/knowledge/loss-aversion/
