Opportunity cost in the stock market

This article discusses the concept of opportunity cost and how it can be applied in your trading.

Dec 23, 2020 09:12 IST India Infoline News Service

In the field of economics, opportunity cost is defined as the ‘next best alternative forgone’. Meaning, that in order to pick a, the alternative option b that was not chosen is then the opportunity cost of picking a. Opportunity cost in the stock market is a constant. Every time an investor takes a trade, they are picking that trade over another. One could say that every trade taken, has an opportunity cost, with there being no exceptions to this rule.

One might however, be able to use their understanding of the concept of opportunity cost in the stock market in order to better the trades they take or more specifically, minimise their opportunity cost and maximise returns. Meaning, picking the best possible option while ensuring you are not giving potentially higher returns on another investment you could have made instead.

This article will explore the concept of opportunity cost that can be implemented in day to day trading endeavours in order to become a more seasoned investor.

Opportunity cost while investing

When an investor takes a trade, there is always an opportunity cost to the trade you are currently taking, that is unavoidable. The focus instead should be on ensuring that the opportunity cost of making this investment is not greater than the returns you earn from your investment of choice. For instance, if you buy stock X in the stock market, your opportunity cost in the stock market of buying X would be stock Y. While you cannot avoid having to pick one over the other, you must ensure that X was in fact the better investment, meaning it gives you a higher return that investing in stock Y would. If, however, this is not the case and investing in stock Y would provide better returns, then your opportunity cost in the stock market is too high.

Opportunity cost in the stock market is prevalent not only when you purchase stocks, but the selling of a stock has opportunity costs as well. In this scenario however, the opportunity cost of selling a stock is the possibility of holding onto that stock. In order to exemplify, assume that you purchased a stock at 150 Rupees a share, and this price has since reached 200 Rupees. You are now posed with a choice; either you sell off your stock and take 50 Rupees per share as your profit, or you hold on to the stock in hopes of the price rising further. Here, the goal is to ensure that you divest or sell off your stocks at the right time. If for example you choose to hold on to your stock and the price falls, then the opportunity cost of holding onto the stock is higher than the opportunity cost of selling the stock. Similarly, if you sell at 150 but the price soon hits 200, then the opportunity cost of selling your investment at 150 Rupees is the extra 50 Rupees you missed out on by choosing not to hold onto your investment further. While it is clear from the above examples it is clear that in most cases, it is impossible to know for sure if you will be able to minimise your opportunity cost. However, with the proper technical analysis tools alongside the relevant market information, one could aim at minimising their opportunity cost

There is an opportunity cost to everything

Believe in it or not, opportunity cost in the stock market is not limited to simply taking or taking trades in the stock market. There is also an opportunity cost to no action taken in the stock market. Let’s explore this in detail a little further.

Let’s say for instance, you are an investor with the ability to invest 1 lakh a year. If you chose to invest that 1 lakh in certain companies, the opportunity cost in the stock market would be the other companies you could have invested in. However, if you chose to not invest that money, then the opportunity cost of not making an investment would be the potentially one lakh worth of investments you could’ve made. Now, it is also worth keeping in mind that when you keep your money in your bank account, you accumulate interest. The opportunity cost of this interest you receive is the potential investments you could’ve made. Additionally, if you invest the one lakh and receive returns that are less than the interest you could’ve owned by keeping the money in the bank, then the opportunity cost of taking those investments is the interest payments you let go off. If you were to take trades that would give you returns less than the interest rate, then your opportunity cost is too high, and you would’ve been better off keeping the money in the bank.

Conclusion

Opportunity cost in the stock market can be successfully understood and subsequently minimised with the help of supporting strategy and technical analysis. However, one must also be watchful in order to ensure that they do not end up forgoing a good investment in a stretch to minimise opportunity cost. If one is too careful, they might let a good opportunity go by. A good balance is required.

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