What is the opportunity cost when investing?

Classroom

oi-Roshni

By Roshni Agarwal

Published: Monday, November 11, 2013, 14:16 [IST]

General economics holds that opportunity cost is the opportunity foregone by taking one course of action instead of the other possible alternative. Like other areas, opportunity cost also applies to investing and it is the cost that one has to bear at the cost of other investment decision. The cost can be in the form of associated return, risk, safety of the investment instrument, liquidity etc. Simply put, it is the investment decision made at the expense of other available investment option and also the benefit of holding the funds in cash.

Illustration explaining the opportunity cost associated with one investment decision over other :

Opportunity cost is nothing but the difference in return between the selected investment option and the other available alternative. Consider if an investor invests in a stock that surges in value by a mere 2% in a year's time, investor fore-goes the return from other investment option such as a risk-free government bond that yields 8%. So, the opportunity cost in the present situation turns out to be 6% (8% - 2%).

So, while deciding on the investment instrument for the purpose of investment one should also diligently evaluate the opportunity cost associated with the investment as there can be other investment baskets meeting one's financial goals and at the same time providing better returns. The understanding of the concept of opportunity cost involved in investment decisions results in a better investment portfolio and also give emphasis to the quality of capital allocation.

For conservative investors or investors with low risk appetite stock trading is a high opportunity cost. So, while investment in fixed income instruments on the part of conservative investor guarantees fixed returns one has to fore-go potential of high returns by investment in equity.

Likewise, for investors with high-risk profile who are willing to take high-order risk, investment in conservative instruments is a huge opportunity cost. So, any investment haven providing higher returns is certainly not the best investment option and indeed the option that suitably meets the need and investment objective of the investor would prove to be best.

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