Opportunity Cost in the Stock Market
Author: James Clark
Opportunity Cost in Stock Trading
Every stock trader has to deal with trade-offs when choosing one stock over another that promised higher returns. The stock market comprises thousands of stocks and investment choices traders can make, and there will always be a stock that you could have invested in that would have scored a higher profit. This is why learning about opportunity cost in the stock market is essential so you can focus on finding investments that suit your long-term goals.
Read on to learn about opportunity cost in stock trading and how to calculate it before making a trade decision
What is Opportunity Cost in the Stock Market?
Everyone has to deal with trade-offs in their lives, and it’s no different in trading. Opportunity cost in stock trading is when investors lose money after trading off stocks with a higher reward-to-risk ratio. Inexperienced traders are more likely to do this because they don’t understand the concept and face unbearable losses and shorten their trading hobby or career.
Usually, when new investors first dive into the stock market, they don’t fully comprehend the consequences of stock selection. Wasting money on unnecessary trades can affect future profit-making opportunities. Hence, traders must learn how to effectively anticipate the success of their trade by calculating the opportunity cost.
For example, an investor loses $1,000 on a bad trade. Over time, the loss exceeds $2,000 and more. By the time the market condition finally turns in their favor, it will be too late for the trader to capitalize on the opportunity because they no longer have the required funds.
Besides financial loss, another opportunity cost most traders overlook is the cost of the psychological impact of the loss sustained. When an investor loses money on a bad trade, they regret their decision and potentially shatter their confidence which will affect their future trades.
How to Calculate Opportunity Cost in Stock Trading
Fortunately, the formula for calculating opportunity cost in stock trading is straightforward. All you have to do is calculate the difference between the expected returns on investment of both trades.
Opportunity Cost = Return on foregone stock (FC) – Return of chosen stock (CC)
Suppose you have two options. The first option is to buy more stocks to expand your stock portfolio and hopefully generate higher capital gain returns. The second option is to reinvest the money in your business transformation and increase profit by improving operational efficiency. Assume your stock investment is expected to generate 15% returns in one year, whereas the business transformation option is expected to generate 11%.
The opportunity cost in this case is, 15% - 11% = 4%. By reinvesting in your business, you’re trading off the opportunity to potentially earn a higher return.
Opportunity cost might be a relatively abstract concept, but economically speaking, its impact is very real. Many businesses and investors fail to account for it when making a trade or business decisions. By understand opportunity cost in the stock market, you can make educated decisions when choosing from multiple trades.
1. Penske Automotive Group (PAG)
2. Canadian Natural Resources (CNQ)
3. ManpowerGroup (MAN)
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