What does opportunity cost mean for your finances?

Opportunity cost is an important concept that you should consider for almost all decisions you make

June 12, 2013 3:09 IST | India Infoline News Service

Opportunity cost is a benefit or profit that you pass by to acquire or achieve something bigger. It is mostly used to analyse decisions that require allocation of money by companies or individuals.

For instance, you have a finite sum X which you need to invest among four stocks A, B, C and D. Let's say after a proper due diligence, you invest in stock A. After a month, prices of all four stocks increase. However, the price of stock C rises the most. Now, you measure your opportunity cost against stock C as its price increased the most. Thus, earlier you had an option to invest in stock C and earn more gains. However, you lost this opportunity.

Thus, opportunity cost refers to the benefit which you could have got by taking an alternative action. Similarly every resource (land, money, time, etc) can be put to alternative uses, every action, choice, or decision has an associated opportunity cost.

Let's take another example: You have two options—go to college and study or start working and earn money. The opportunity cost of going to a college is the money you would have earned if you worked instead.

In the above two examples, a choice among the options available to us must be made. It would be an easy decision if you knew the end outcome. However, there is a risk that you would achieve greater 'benefits' — monetary or otherwise — with another option.

Thus, opportunity cost is worth considering before arriving at decisions. Before investing, ask yourself if I invest the same amount of money elsewhere, will I earn a higher profit or benefit. You need to check whether you would get better risk-adjusted returns.

Opportunity cost in repaying loans

Opportunity cost can be very useful while repaying your debts. Suppose you have received lumpsum money like gratuity or bonus. You have two options: Pay back partially or in full your housing loan that may be outstanding or invest in a financial instrument to earn returns.

Analyse the opportunity cost of using the money which goes into repayment before making the any other investment decision. If you have an outstanding loan of Rs. 5 lakh at an interest rate of 10% per annum, you can either choose to repay the loan and live a debt-free life or invest the money in a product that gives you at least 11% per annum.

Thus, the opportunity cost of repaying the loan, in this case, is the additional earning that you have to forego unfortunately.

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