Opportunity Costs Associated With Investing

There is an opportunity cost for every decision we make as individuals; as investors, these decisons can determine whether we make good returns on our investment or whether we lose out completely

The concept of opportunity cost plays out every single day. Simply defined as the opportunity foregone, opportunity cost is the cost that comes with doing one thing over the other. Let’s use Kojo as an example here.

Kojo is a typical Nigerian man. Stereotype or not, this man does not joke with his Nkwobi, pepper soup with goat meat, and never skips Friday night drinks with the guys. You can say he knows how to live his life.

The only problem is that Kojo is so happy to live in the moment, after all YOLO, that he forgets that he needs to plan and invest in his future. This is probably the worst kind of opportunity cost there is – the one that involves sacrificing your future wealth and financial security/stability for current gains. Don’t do it.

For the investor as well, there is an opportunity cost that comes with investing in one thing as opposed to the other. By investing in one thing over the other, you are losing out on all the possible benefits of the other.

The reason investors need to understand the concept of opportunity cost, however, is to ensure that they make the best investment decisions. Every investment decision must be calculated bearing in mind the possible investment opportunities forgone and the goal is to always take the more profitable decision.

Carelessly choosing investments based on impulse or chance will simply not cut it.

In determining the opportunity cost of an investment decision, there’s a simple formula to employ:

Opportunity cost = Return on best forgone alternative – Return of chosen investment option.

Let us go back to Kojo’s decision to party hard over investing and assume that he partied for a full year without saving or investing. Assuming he could have invested in a security that would yield 20% by the end of the year, the opportunity cost is 20%.

Hence, he could have invested N500,000 making a profit of N100,000 extra.

If he saved N500,000 and didn’t invest, the opportunity cost of his decision is the N100,000 but Kojo’s case is even worse because he doesn’t even have the capital to show for it.

If, Kojo was an investor and the investment decision he made was going to yield 10% that year, based on our formula, the opportunity cost would be 10%. That is, 20% which is the best alternative forgone minus 10% which is the return of the chosen investment decision. The opportunity cost is therefore 10%.

The reality of investments is however more complicated. This is because of the risk element that every investment carries. It becomes hard to determine the actual return of any investment because you wouldn’t know until it is over.

In fact, in most cases with stock investments, the volatility might make it too hard to track. The best you can do is compare the returns made by the end of a given period with returns made in a fixed interest investment that yields little value.

The best advice is to determine the most favorable investment strategy that suits your investment goal and follow it through till the end.

Written by Lawretta Egba.