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Opportunity cost

Lesson in Course: Investing basics (beginner, 4min)

We experience regret. How can Robert Frost help us make better financial decisions?

Eureka!

What it's about: Opportunity cost is the benefit we could have had if we made a different choice.

Why it's important: Considering the potential benefits of each choice leads to better decision-making, more confidence, and less regret.

Key takeaway: Slow down to make thoughtful and intentional investment decisions rather than emotional and irrational ones.

Regret is that sad feeling we get when we wish we had made a different decision. When was our last "should have, could have, would have" moment? Perhaps we were disappointed in the outcome of a decision we made and probably felt like we missed an opportunity. We'll need to overcome regret to build confidence in our investment decisions.

The road not taken

Robert Frost wrote a famous poem, The Road Not Taken, about how taking the path less traveled made all the difference in his life. In the poem, he describes a familiar situation, standing at a fork in the road and making a choice.

We constantly make decisions between multiple paths. Some decisions are small, like what to order at a restaurant. Others are much larger, like whether to go to college or what investments to make.

Every choice leads to a different outcome

However, all decisions have an opportunity cost.

What is Opportunity cost?

Opportunity cost is the benefit we could have had if we had made a different choice. 

When making a decision, we often only think about the cost associated with our choice while ignoring the choices we didn't make. Considering the potential outcomes of different options is part of making a better-informed decision.

 

Where paths diverge

Each investment choice has its own pros and cons

When faced with an investment decision, applying opportunity cost means listing out each of the potential outcomes in addition to how much cash we need for each. Then, compare and choose the one that we expect will give us the best chance to reach our goals. We'll experience less regret and more confidence because we knowingly passed up the potential benefits of a different choice ahead of time. 

No matter how hard we try, things don't always go as we expect. It's usually because of something we didn't consider or we can't control. However, using opportunity cost enables us to learn from our mistakes (because everyone makes mistakes) rather than regret them. We can go back to our list to identify where we went wrong or what we missed and factor that in next time.

One of the most challenging decisions we inevitably face is when we've made bad investments. It's hard to decide whether to take losses and sell or hang on while the price is dropping.

How the best investors use opportunity cost
Top 10 Warren Buffett Quotes To Inspire Your Investment Goals

Warren Buffett, one of the most successful investors, stood at this same fork in May 2020. COVID-19 hit, and the value of airline stocks that he owned plummeted. Does he hang onto them hoping that things will turn around, or does he sell them? 

The opportunity cost of holding the airline stocks is the return from other possible investments that he could make elsewhere. He decided he was better off selling those stocks and investing that money elsewhere. 

Buffett had to realize losses in the ballpark of $5 billion!!! We can be sure many people weren't too happy about that decision. However, market movements and a few investments he made afterward racked up a $10 billion gain by November 2020.

 

Actionable ideas

Think about what your investment goals are and consider the potential benefits of making a different choice. You aren't trying to come up with every possible choice. The point is to slow down, so you make thoughtful and intentional investment decisions rather than emotional and irrational ones.

Maybe you came into some extra money, and you're thinking about going on a little shopping spree. Using opportunity cost means looking at the cost of buying a new pair of shoes differently. It isn't just the money you spent to buy them; it includes all of the potential gains if you had invested that money instead.

Let's say you want to invest that money; where do you invest it? If you put it in a retirement account, it could be many years (even decades) before we can access it. You'd give up your ability to spend it while it's in the retirement account.  

Perhaps you know where to invest it, but you're torn between different types of investments, say high-growth stocks or dividend stocks. If you invest in growth stocks, realize the opportunity cost is the income and returns you could have generated by making a different investment. 

Most importantly, think about how the opportunity cost of each choice relates to your investment goals. When you've made your decision, be confident and open to learning from your mistakes.

Supplementary materials

This short video walks through a few examples and how we can think about using opportunity cost.
https://www.youtube.com/watch?v=SA16Qw09bXM&ab_channel=EconClips

Glossary

What is Opportunity cost?

Opportunity cost is the benefit we could have had if we had made a different choice.