The opportunity cost of holding money is the amount of money that could have been made by investing the money instead of holding it. In other words, it is the amount of interest money earns when it is invested in a certain way.
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What Is the Opportunity Cost of Holding Money?
The opportunity cost of having cash is the amount of money that might have been invested instead of kept. In other terms, it is the rate of return earned on a certain investment. Typically, the interest rate on a bond, particularly a government bond, is what is determined.
Given the various possible investment options, this cost might vary greatly from one individual or organization to another. To calculate the real opportunity cost of keeping cash, it is important to first identify the alternative investment vehicle. The subsequent stage is to investigate the investment strategy’s expected rate of return.
If the annual percentage rate is one percent, then the opportunity cost of hanging onto the money would be one percent yearly. Prior to assigning a value, it would be necessary to determine how much money is being stored and for how long.
Investing and keeping cash are mutually incompatible options in economics. This means that neither can be completed simultaneously with the same funds. When funds are invested, they cannot be held. A person may be able to alter his or her opinion about the best option for that sum of money, but the two tactics cannot be executed concurrently.
There may be legitimate reasons for not investing, despite the fact that most firms and individuals would prefer to have their money working for them rather than merely being kept. Keeping cash on hand affords organizations a degree of economic flexibility since funds stay relatively liquid.
This permits a firm to make swift decisions using at least a portion of its available funds. Additionally, holding cash often involves less risk than investing it. Depending on their objectives, these business decisions will vary from one company to another.
The opportunity cost of retaining cash is considered an explicit cost as well. This indicates that costs are incurred due to the ineffective use of a company’s own resources, in this instance money. Contrast explicit costs with implicit costs, which are intangible expenses that are sometimes impossible to quantify with an exact figure.
When deciding whether the opportunity cost of retaining cash is worthwhile, a company must consider a variety of criteria. For instance, if the firm could act on a product or purchase that would yield a higher return on investment than current interest rates, it would be advantageous to retain the funds. Often, determining the optimal option requires predicting and calculating all explicit costs.
What Opportunity Cost Can Tell You
Opportunity cost analysis is vital in defining the capital structure of a corporation. In addition to incurring a cost when issuing debt and equity capital to pay lenders and shareholders for investment risk, each incurs an opportunity cost.
For example, funds used to make loan payments cannot be invested in stocks or bonds, which offer the possibility of investment income. The corporation must determine if the expansion enabled by the leverage of debt will yield more earnings than investments.
A company attempts to balance the costs and advantages of issuing debt and equity, taking both monetary and nonmonetary factors into account, so as to minimize opportunity costs. Due to the fact that opportunity cost is a concern for the future, the real rate of return (RoR) for both choices is now unknown, making this judgment difficult in practice.
Consider that the corporation in the above example foregoes purchasing new equipment in favor of investing in the stock market. If the selected securities decline in value, the corporation may incur losses instead of the anticipated 12 percent return.
Assume, for the purpose of simplicity, that the investment provides a return of 0%, indicating that the corporation receives exactly what it invested. The opportunity cost of selecting this choice ranges from ten percent to zero percent, or ten percent.
It is also feasible that if the corporation had chosen new equipment, production efficiency and earnings would have remained unchanged. In this case, the opportunity cost of selecting this choice is 12 percent, as opposed to the projected 2 percent.
It is essential to examine investing choices with comparable risk. A computation can be deceptive if it compares a Treasury bill, which is nearly risk-free, to an investment in a highly volatile company.
Both options may have projected returns of 5%, but the RoR of the T-bill is backed by the U.S. government, whereas there is no such assurance for the stock market. Despite the fact that the opportunity cost of either option is 0%, the T-bill is the safer investment when considering the proportional risk of each choice.
When evaluating the potential profitability of various investments, companies choose the choice that is most likely to generate the highest return. Typically, they may ascertain this by examining the anticipated RoR of the investment vehicle. In addition, firms must assess the opportunity cost of each alternative choice.
Assume that a firm with $20,000 in available capital must choose between investing in stocks or purchasing new equipment. Regardless of whatever choice a corporation picks, the opportunity cost is the potential profit lost by not investing in the alternative option.
If the firm chooses the first option, its investment will be worth $22,000 at the end of the first year. RoR is calculated using the formula [(Current Value – Initial Value) Current Value] 100. In this instance, [($22,000 – $20,000) $20,000] 100 = 10%, hence the RoI on the investment is 10%.
For the purposes of this illustration, let’s assume that it would yield 10 percent year thereafter. At a 10% RoR with compounding interest, the investment will grow by $2,000 in the first year, $2,200 in the second year, and $2,420 in the third year.
Alternatively, if the company acquires a new machine, it will be able to produce more widgets. The machine installation and personnel training will be lengthy, and the new equipment will not reach optimal efficiency for at least two years.
Let’s say it would add $500 to the company’s earnings in the first year, after accounting for the increased training costs. The business will generate a profit of $2,000 in the second year and $5,000 annually afterwards.
Because the corporation has limited resources to spend in either option, it must choose. Accordingly, the opportunity cost of selecting the securities is rational during the first and second years. In the third year, however, an examination of opportunity cost reveals that the new machine is the superior choice ($500 + $2,000 + $5,000 – $2,000 – $2,200 – $2,420 = $880).
The Difference Between Opportunity Cost and Sunk Cost
A sunk cost is money that has already been spent, whereas opportunity cost is the future profits that could have been gained on an investment but were not because the capital was invested elsewhere.
For example, purchasing 1,000 shares of business A at $10 per share implies a sunk cost of $10,000. This is the sum paid out to invest, and recovering it involves selling the stock at or above its acquisition price. But the potential cost asks where the $10,000 may have been utilized more effectively.
From an accounting standpoint, a sunk cost might also refer to the initial outlay to acquire a costly piece of heavy equipment, which may be amortized over time but is sunk in the sense that it cannot be recovered.
When deciding between two pieces of heavy equipment, one with a predicted ROI of 5% and one with a ROI of 4%, the opportunity cost would be the lost returns that could have been generated elsewhere.
Again, opportunity cost refers to the returns that could have been obtained had the funds been invested in a different vehicle. Thus, whereas 1,000 shares of business A might be sold for $12 per share, yielding a profit of $2,000, shares of company B rose in value from $10 to $15 within the same time frame.
In this situation, a $10,000 investment in business A yielded a return of $2,000, but the identical investment in company B would have yielded a return of $5,000. The difference of $3,000 is the potential cost of selecting firm A versus company B.
As an investor who has previously invested money, you may discover another investment that offers larger returns. The opportunity cost of retaining the failing asset may escalate to the point where selling it and purchasing the more promising investment is the reasonable investment decision.
Opportunity Cost and Risk
In economics, risk refers to the chance that an investment’s actual and expected returns may differ and that the investor would lose some or all of the principal. Opportunity cost refers to the chance that the returns on a selected investment will be less than the returns on an alternative investment.
The primary distinction between risk and opportunity cost is that risk compares the actual performance of an investment to its expected performance, whereas opportunity cost compares the actual performance of an investment to the actual performance of another investment.
Still, opportunity costs might be included when choosing between two risk profiles. If investment A is hazardous but yields a 25% ROI, whereas investment B is far less risky but yields a 5% ROI, investment A may or may not succeed. And if it fails, the opportunity cost of option B will become apparent.
Example of Opportunity Cost
Before making major financial decisions such as purchasing a home or establishing a business, you will likely conduct extensive study on the benefits and drawbacks of your choice. However, most day-to-day decisions are made without a complete grasp of the possible opportunity costs.
Before making a purchase, many individuals may check the amount of their savings account if they are feeling hesitant. However, they rarely consider the sacrifices they must make while making a buying decision.
The issue arises when you never think what else you might do with your money or when you purchase items without contemplating the opportunities missed. Occasionally ordering takeaway for lunch can be a good choice, especially if it allows you to escape the workplace for a much-needed break.
Buying a cheeseburger every day for the next 25 years might, however, result in several missed chances. Aside from the wasted chance for improved health, spending $4.50 on a burger might accumulate to just over $52,000 over the course of ten years, assuming a very attainable 5 percent RoR.
This is a basic illustration, but the underlying concept applies to a number of circumstances. It may seem excessive to consider opportunity costs if you want to purchase a candy bar or go on vacation. But opportunity costs are ubiquitous and accompany every action, regardless of size.
Is opportunity cost a real cost?
Opportunity cost is not directly reflected on a business’s financial accounts. However, from an economic standpoint, opportunity costs remain quite significant. Yet, because opportunity cost is a very abstract term, many organizations, executives, and investors fail to take it into account while making everyday decisions.
How to Calculate Opportunity Cost
The essential formula for opportunity cost is same in both academic economics and common use; it is only phrased differently.
“In economics, opportunity cost is the expected return on the Foregone Investment Option (FO) minus the expected return on the Chosen Investment Option (CO),” explains Houston, Texas’s Todd Soltow, co-founder of Frontier Wealth Management. The formula for opportunity cost is:
Opportunity Cost = Forgone Option – Chosen Option
When it comes to investment returns, you need just substitute the predicted rates of return for each alternative. If you are considering between an exchange-traded fund (ETF) with a projected return of 10 percent and a rental property with an expected return of 8 percent, the opportunity cost of selecting the rental property is 2 percent.
When estimating opportunity costs, it is essential to take into account more than just flat returns. You should also consider the amount of risk associated with your options.
In general, the larger the risk of losing money on an investment, the greater its rewards. Therefore, it can be difficult to compare the opportunity costs of highly hazardous assets, such as individual stocks, with investments that are nearly risk-free, such as U.S. Treasury bonds.
On paper, there may be a substantial opportunity cost associated with choosing Treasuries over equities, but the security that Treasuries provide may make them desirable in some circumstances, such as if you needed immediate access to the funds.
How Opportunity Costs Impact You as an Investor
It is evident that investment decisions are inevitably influenced by opportunity cost. However, once you realize opportunity cost is a component to consider, the number of options to examine may appear overwhelming.
After all, you don’t want to pick the incorrect investment option and suffer the incorrect opportunity cost.
“The next stage is to examine the possible return on every stock, bond, piece of art, non-fungible token (NFT), and cryptocurrency accessible for investment,” says Doug Milnes, a certified financial analyst (CFA) at MoneyGeek.com in New York, New York, in an effort to maximize your profits.
“Thanks to years of study and analysis, portfolio theory has been developed, allowing investors to bypass the labor of appraising each investment possibility.”
Carefully formed portfolios give guidance for the proportion of each asset type to hold in order to limit the risk of a single asset or asset class performing exceptionally well or poorly over time. “This simplifies the investor’s decision-making to a simple question of how much of each asset type to hold,” he explains.
These asset allocations are normally based on your investing timeline and desired level of risk. The shorter your timescale, the more conservative your assets, such as bonds and bond funds, should be.
But for longer-term objectives, you may position yourself for higher returns by increasing the proportion of riskier investments, such as stocks and stock funds. (Check out the Forbes Advisor guide to saving for retirement for guidelines for retirement portfolios.)
Remember that regardless matter the decision you choose, you will pay some type of opportunity cost. Even making no decision is a costly option, especially when inflation’s hidden costs are included.
Sweta Bhargav, a financial adviser with Advisor Wealth in Philadelphia, states, “Resources are finite in life, particularly commodities, services, money, and time.” There is always a cost and benefit. Therefore, opportunity costs are really a matter of determining which trade-offs you can accept.
In general, the opportunity cost of holding money is the amount of money that could have been made by investing the money instead of holding it. . The interest rate on a bond, especially a government bond, is set most of the time. Since there are other ways to invest money, the cost for each person or group could be very different.
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