Individual, investors, and corporates apply the concept of opportunity cost in their day-to-day activities. Also known as true cost, it is the benefit missed or given up when an individual chooses one alternative over another.
Let’s use Steven as an example. He loves hanging out with friends every Saturday. He is so euphoric during those moments that he expends N50, 000, a quarter of his pay, on drinks. Steven does not save, not to talk of investing to earn passive income.
This is the extreme case of opportunity cost, when an individual trades his future financial stability for current gains.
Understanding how opportunity cost works helps you as an investor to make intelligent investment decisions.
An investor whose objective is to maximize returns, every investment decisions must be carefully calculated, noting the possible investment opportunities forgone.
Making investment decisions based on emotions, chance or impulse, without meticulously considering alternatives is not a way to go.
To ascertain the opportunity of an investment decision, the return on best-forgone alternative should be deducted from return on the selected investment option. If the value is positive, it implies that investor has made the best decision, and vice-versa.
Going back to Steven’s decision to expend a quarter of his pay, to catch fun with friends ahead investing, and assuming he invested in 364-treasury bills that would yield 12.54 percent at the last primary market auction, his opportunity cost is 12.54 percent return he misses on the security.
Thus, he could have invested the N50, 000, to get N6, 245 extra, the opportunity cost of his decision is worse as he couldn’t even produce the capital, (N50, 000).
If Steven was an investor, and he decided to keep the sum in a term account with Bank XYZ, that will yield five percent for 12 months, his opportunity cost being 7.54 percent or N3, 745.
That is 12.49 percent on 364-treasury bills, which is the best alternative forgone less 5 percent, the return of the selected investment decision, making his opportunity cost 7.54 percent.
The reality of investments is, however, more complicated because the risk element every investment carries makes it pretty difficult to ascertain the actual return on any investment.
This is more applicable in equity investment, in which the volatility involved makes it difficult to study. What investors can do is to compare the returns realized at the end of a given period with returns on other asset classes.
According to Lawrette Egba, a personal finance expert, the best thing for you as an investor is to know your most favourable investment strategy that fits your investment objectives and apply it till the end.
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