Quick Answer
Opportunity cost is the return an investor gives up by choosing one investment over the next-best alternative. If the chosen investment still earns a return, the cost is the extra return the alternative offered (alternative minus chosen). It is a foregone gain, not an actual loss, so it is implicit rather than explicit.
Because opportunity cost never appears on an account statement, exam questions often test whether you can spot it in a scenario where nothing was technically "lost."
What Is Opportunity Cost?
- Definition: the return given up by choosing one investment over the next-best alternative
- When the chosen investment still earns a return, the opportunity cost is the extra return the alternative offered: the alternative's return minus the chosen investment's return
- When the chosen investment earns nothing, such as idle cash, the opportunity cost is the alternative's full return
- Applies to every investment decision; choosing bonds over stocks means forgoing the potentially higher equity returns, and vice versa
- Also applies to holding cash: the opportunity cost of keeping money in a savings account is the higher return that could have been earned in the market
- Not a direct financial loss; it is a foregone gain, making it an implicit cost rather than an explicit one
- Opportunity cost is a factor in risk tolerance discussions: risk-averse investors accept lower returns, and higher opportunity cost, in exchange for lower risk
How Do You Calculate Opportunity Cost?
- Find the next-best alternative's return, then subtract the return the chosen investment earned
- Example: a client puts $80,000 in a portfolio returning 5% when the next-best comparable portfolio returns 8%. The opportunity cost is 8% minus 5%, or 3 percentage points (about $2,400 on $80,000)
- The 8% is not the cost, because the client still earned 5% of it. The 5% is not the cost either, because it is the return actually received
- A positive return does not remove the cost. The portfolio can finish above its starting value and still carry an opportunity cost
How Does the Exam Test Opportunity Cost?
- An investor who holds cash during a bull market incurs an opportunity cost equal to the market gains they missed
- An investor who locks into a long-term bond at 4% has an opportunity cost if rates rise to 6%, since they are stuck at the lower rate
Exam Tip: Gotchas
Opportunity cost is not the same as an actual loss. It is the foregone return from the next-best alternative. The exam may present scenarios where an investor "lost" nothing in absolute terms but still incurred an opportunity cost by choosing a lower-returning investment.
What Should You Check on Exam Day?
- Can you distinguish a foregone gain (opportunity cost) from an actual realized loss?
- When a question gives both the return earned and the return of the better alternative, can you subtract to find the extra return given up?
- Do you recognize opportunity cost in a cash-holding or locked-in-bond-rate scenario, not just in a textbook definition question?
- Can you connect opportunity cost to a risk-averse investor's tradeoff between lower risk and lower return?