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What is opportunity cost?

POSTED ON MAY 14, 2021    

In investing, opportunity cost is what you lose by taking Investment A over Investment B, or C, or D. It is the profit you didn’t earn because you put your money elsewhere.

 

In Millennial terms, we call this FOMO or the Fear Of Missing Out.

 

In mathematical terms, Opportunity Cost (OC) is calculated by subtracting the projected returns of one investment product (A) from another (B). So, OC = A – B.

 

For example, imagine that you had P10,000 to invest for 3 years, and were choosing between investing in an equity Unit Investment Trust Fund (UITF) and a Real Estate Investment Trust (REIT). The UITF could potentially grow by 10% and the REIT may give you 8%.

 

If you were to choose the REIT, OC = 8% (REIT) - 10% (UITF). Your opportunity cost would then be -2%. This means that investing in the REIT would possibly give you P200 (2% of P10,000) less than what you would get by putting your money in the Equity UITF.

 

Note though, that in this example you're basing your decisions on historical data. Remember that OC can also be computed after the fact just for you to back-check if you’ve made the right decision. Or not.

 

Consider other factors too

Opportunity cost is just one of the things you should look at when comparing investment products. You should also look at the risk suitability of the products. If one is fit for a higher risk profile than the other, you need to consider that as well.

 

It might not be a healthy comparison if you pit a money market fund against a high conviction equity fund.

 

Other factors such as liquidity (the ease in which your investment can be turned into cash) and the products’ recommended time horizon can also help you choose which product you should put your money in.

 

Projections aren’t always right

Calculating the opportunity cost can be very useful in helping choose the right product. Just remember that it is based on projections, and so is not a sure thing. The actual returns may be higher or lower than what was expected.

 

Your investing journey is full of choices that you alone must make. From what products to invest in to how much to invest, you’ll need to make decisions that could impact your experience and, of course, your profits. Basing these decisions on facts and not emotions is the right way to go.

 

If you are still having a difficult time choosing one over the other, perhaps it’s a sign for you to get both – for a more diversified portfolio.

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