When you wake up in the morning, you may not realize financial concepts are already at play. If you wake up late, you may have to decide to skip the coffee line and head straight to your client meeting. Skipping the line for a quick pick-me-up drink to speak with your important client is an example of opportunity cost. Every time you choose between two things that could be good or best, you give up one choice in favor of a higher potential reward.
Financial Concepts: Opportunity Cost
Professional investor Jason Fernando defines the financial concept of opportunity cost as “the potential benefits that an individual, investor, or business misses out when choosing one alternative over another.” (See investopedia.com) In other words, when you have to pick between two things, sometimes you might miss out on good things that the thing you didn’t pick could have given you. However, you should remember how a good thing now can be given up in exchange for a long-time reward.
Financial Concepts: Return on Investment
Taking your new basic understanding in hand, I would say there is a strong correlation between the financial concepts of opportunity cost and return on investment. Return on investment is like staying an extra hour for a few weeks at work so you could enjoy a party and celebrate your accomplishment. Peter Carleton from Investing Answers Inc. states that return on investment is “a key financial ratio that measures the gain/loss from an investment about the initial investment.” (See investinganswers.com) That is to say, money towards real estate instead of fancy company lunches every month may prove to yield a higher return on investment. The opportunity cost is whether you want to invest time back into your employees or put it forward toward your next acquisition.
Financial Concepts: Real-World Example
Now I would say it’s fair and well to go about doing business after already understanding these financial concepts, but what if you still don’t know how these two principles work? Here, I will provide you with a real-world example of both opportunity cost and return on investment.
The Choice
Let’s say you are given a choice between $1,000,000 in education and a $.01 compounding investment right now. The catch is that one penny will double in value in just 31 days. Some would say the million dollars is a no-brainer, but that could be flawed logic. If you took the million dollars and tried to make money back, you would spend more time and money just learning about how to invest. However, you would gain instant access to a great wealth of knowledge with enough money to hire the greatest educators. Yet, despite spending significantly more money than if you were to let a penny double in value, there is still value in taking the $1 million bonus.
Wait or Collect?
On the other hand, after just 31 days, your $.01 now becomes over 10 million dollars. Now your real question is whether you should wait. Or, you collect the $10 million or just start with the million right now. This is an opportunity cost. I would say you should define clear goals before making your choice here. If your goal is to just make money, then the $10 million is the clear winner. If I wanted to invest in my future and educate myself about investment opportunities now, then I would take the $1 million now. Then, with time, I would become an expert in growing my wealth and even helping other like-minded investors do the same.
Learn and Adapt
Your return on investment with the $1 is unclear at the beginning. This it depends on your willingness to learn quickly and adapt to becoming a better investor. However, you may have the potential to make even a billion dollars. Of course, this comes if you make sacrifices to put in the time and effort. The opportunity cost is whether you would like to invest in your future. This is through taking a large scholarship check or withdrawing a large sum of money in a month. The danger of taking the large sum is lack of knowledge and knowing what to do next.
Closing Thoughts
My hope is that you will take away something from this and apply it to your investment portfolio. You might be starting out on your financial journey. You could even be close to achieving your retirement goals. I goal is to have something here for you. I would take the key away concept I learned. Then, I would learn to move forward and make smart financial decisions today and in the future.
