Tuesday, July 6, 2010

Investing Your Choice

Opportunity cost. We all face it everyday. Any decision that we are confronted with that presents two or more choices has an opportunity cost. It is the value of the next best alternative that is given up for choosing to do something else. Opportunity cost is the result of scarcity, which is when our wants outweigh our resources. Basically, humans do not have enough of everything to satisfy our every desire. Each individual has their own personal opportunity cost, which means each person can only determine for themselves the highest-ranked, next-best alternative that they had to sacrifice. However, not all alternatives are considered the opportunity cost. It is important to keep in mind that opportunity cost can only include the next best thing that is given up, not everything that is forgone by making a choice.

An example where opportunity cost comes into play is the idea of investing. For example, an employee receives an annual bonus of $10,000 and cannot decide between depositing it into a checking account, or investing it. The reason why he wants to invest it is the possibility of earning interest and making money on it. After much thought, he decides to deposit it into his checking account, a more liquid asset, so that he has more accessibility to it. Therefore, the opportunity cost of him depositing it into his checking account is the act of investing it and the interest he would have earned if it were invested in the stock market. Because the employee chose to put the $10,000 into his checking account rather than invest it, he gave up his next best alternative of investment of the money, and the chance to earn more.

Another example of opportunity cost being seen in the financial industry is if a person were to decide to sell a stock for $10,000 instead of waiting to sell it for a chance of earning more money. Nonetheless, if he were to wait, the cost of the stock could also decrease, thus causing him to not earn as much money on the sale. The investor has a decision to make; sell the stock now for $10,000 or wait two months and take the chance of being able to sell it for say, $12,000. Since we do not know what will happen if the investor were to wait to sell the stock, the opportunity cost in this case can only be determined in hindsight.

Lastly, opportunity cost can also appear in the difference of returns between two stocks. Let's say an investor is deciding between two funds to invest in and he has the choice between "Stock ABC" and "Stock XYZ". He chooses "Stock XYZ". Let's also say that "Stock ABC" had an annual return of 6% at the end of 2009, and "Stock XYZ" had an annual return of 4% at the end of 2009. Since the investor gave up the opportunity of another investment ("Stock ABC") by investing in "Stock XYZ", the opportunity cost of not investing in "Stock ABC" would be 2%.

An investor is always faced with decisions, and with these decisions come choices that must be made and render opportunity cost. Whether it be if they are making a choice about where to put their money, what to do with their money once it is invested, or more specifically, what investment options to choose, there are always decisions that must be made in the financial industry. Once these decisions are made, the opportunity cost of the next best choice always shows its face.

When broken down into its simplest form, opportunity cost can be understood quite easily. Every choice you make to do something requires that you give up something else in return. In most cases, you are giving up more than one thing. Opportunity cost is the most highly-valued thing you are giving up to engage in the decision of your choice. It comes down to wants; what a person wants more from a situation. And because of the idea of scarcity mentioned earlier, our wants have always and will always outweigh our resources, causing opportunity cost. The bottom line is each day we are faced with decisions in which we must make choices, and opportunity cost will always be present as a result in every choice we make.

1 comment:

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