Opportunity cost is the potential extra return from one investment compared to another, different investment.
In business, managers must choose how to deploy capital in order to make a profit.
Sometimes, they are presented with two or more alternative paths. Not every venture can be sustained, so opportunity cost represents the profit-making potential of the path not taken.
For instance, say you’re putting together a marketing plan to sell a product and you have two choices.
One is to buy advertising where you’d get a couple billboards, a few commercials on TV and several radio spots over the course of one week.
The other choice is to attend a trade show where you can sell your product. The show costs the same to attend as the advertising buy, but it is just one day long.
You choose to spend the money on advertising and sell 50 products as a result of customers calling in blindly.
Meanwhile, a competitor selling the same product goes to the trade show you skipped and lands a deal with a major retailer. That retailer puts in an order to purchase 20,000 units of the product to sell in stores.
The opportunity cost is the lost revenue or sales that you would’ve received if you had chosen the trade show option. You sold 50 products, but you could have sold 20,000. The 19,950 difference is your opportunity cost.
In investing, we make intentional choices all the time among a variety of possible investments.
If two investments represent the same risk and the same rate of return, it can be hard to distinguish between them.
Over time, however, it might become clear that one of them is superior to the other, offering a better return for the same risk — or the same return with less risk.
Staying in the less attractive investment creates a clear opportunity cost. That might strongly indicate that a change of investments would be smart to consider.
MarketRiders, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.