Opportunity Cost

Lesson

Opportunity cost is the value of the next best alternative that is forgone when making a decision. In the context of investing, opportunity cost represents the potential return an investor could have earned if they had chosen a different investment.

Practice Question #1

Which of the following best describes opportunity cost?

A) The potential loss from an investment

B) The value of the next best alternative that is forgone when making a decision

C) The risk associated with a particular investment

D) The return on an investment relative to its risk

Select an option above to see an explanation here.

A) The potential loss from an investment is a risk, not opportunity cost. B) Opportunity cost is the value of the next best alternative that is forgone when making a decision. C) The risk associated with a particular investment is not opportunity cost. D) The return on an investment relative to its risk is risk-adjusted return, not opportunity cost.

Terms

Opportunity cost:: The value of the next best alternative forgone when making a decision.

Practice Question #2

Which of the following can help reduce opportunity cost in an investment portfolio?

A) Concentrating investments in a single asset class

B) Ignoring risk tolerance when making investment decisions

C) Diversifying investments across multiple asset classes

D) Focusing solely on maximizing returns

Select an option above to see an explanation here.

A) Concentrating investments in a single asset class increases opportunity cost. B) Ignoring risk tolerance can lead to poor investment decisions and increased opportunity cost. C) Diversifying investments across multiple asset classes can reduce opportunity cost by spreading risk and capturing returns from various sources. D) Focusing solely on maximizing returns can increase risk and opportunity cost.

Historical Example

In the early 2000s, investors who chose to invest in technology stocks missed the opportunity to invest in real estate, which experienced significant growth. This represents an opportunity cost, as technology stocks forwent the potential returns from real estate investments.

Practice Question #3

An investor is considering two investments: Investment A with an expected return of 6% and Investment B with an expected return of 10%. If the investor chooses Investment A, what is the opportunity cost?

A) 4%

B) 6%

C) 0.1

D) 0.16

Select an option above to see an explanation here.

A) The opportunity cost is the difference between the expected returns of the two investments, which is 4% (10% - 6%). B) The expected return of Investment A is not the opportunity cost. C) The expected return of Investment B is not the opportunity cost. D) The sum of the expected returns is not the opportunity cost.

Real-World Example

An investor has $10,000 to invest and must choose between investing in a stock with an expected return of 8% or a bond with an expected return of 4%. If the investor selects the stock, the opportunity cost is the 4% return they could have earned from the bond.