Is an opportunity cost a real cost? That’s the question I have been pondering.
I was deciding whether to buy an air ticket a few weeks ago. I saw a good price when I did the search in the morning. I was at work at that time and I decided to make the purchase that evening. When I searched again in the evening, the good fare was gone. The price had gone up by $70. I paid $70 more than I could have.
According to Wikipedia, an opportunity cost is "the next-best choice available to someone who has picked between several mutually exclusive choices." The opportunity cost of waiting until the evening is locking in the low fare right then and there. Its economic value turned out to be $70. This example shows an opportunity cost is every bit real. It cost me real money out of pocket.
In the world of investing, opportunity cost is present at all times. The opportunity cost of investing in bonds is investing in stocks that turn out better, or vice versa. The opportunity cost of investing today is investing on a different day when the price is lower. The opportunity cost of holding on to an investment is selling it before the price goes down.
When an investor has an investment that lost value but the investor is still holding it, the investor is said to have had a "paper loss." There’s a saying "You don’t lose until you sell." Is that right? Is a paper loss not real? Sometimes the investment does recover. When it does, it’s as if the paper loss never happened.
As we’ve seen a paper loss is an opportunity cost and an opportunity cost is every bit real, it follows that a paper loss is indeed a real cost. I believe there is no such thing as a paper loss. A loss is a loss. Whether the investment recovers or not has nothing to do with whether the loss existed or not. If it recovers, there was a loss followed by a recovery. If it doesn’t recover, there was a loss and there is no recovery. In either case, there was a loss.
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Random Poster says
Can’t say that I follow your logic.
In your airline ticket example, the opportunity cost is only “every bit real” because you actually ended up buying the airline ticket. Had you never bought the ticket, you never would have incurred the opportunity cost.
Likewise, until you actually sell an investment, you incur no loss (or gain). After all, an actual loss or a gain (or, if you prefer, an “opportunity cost”) does not exist until you have incurred such a loss or gain.
All I care about it what the price is when I purchase something, and the price of the same item when I sell it. What happens in the interim period of time is completely meaningless to me and, consequently, is most assuredly not “every bit real.”
David H. says
An opportunity cost always exists. If you’ve taken a micro/macro course you will learn that economic profit is equal to accounting profit less opportunity costs. By deciding to do a MBA, I gave up working. Working and making $$ is my opportunity cost of doing an MBA. If you are rational, you should be considering this always.
Harry Sit says
@Random Poster – I had to buy a ticket sooner or later. That same ticket costs hundreds of dollars more today. There’s this story in the book Why Smart People Make Big Money Mistakes and How to Correct Them by Gary Belsky and Thomas Gilovich:
A guy found $5 and went to the casino. With extraordinary luck, he turned $5 into millions before he lost is all. When he came back to his room, his wife asked “How did you do?” He replied “Not bad. I lost five dollars.”
That’s a guy who didn’t care about what happens in the interim.
Random Poster says
@ TFB – That’s an interesting story, but it has limited application in the investing world, at least as to those investors who invest solely with their own money and never on margin. Whereas a gambler in a casino could (theoretically) lose well more than what they started out with ($5, to use your example), a use-your-own-money investor in the stock market can never lose more than what they started out with.
Furthermore, your example assumes that a rational investor would not try to take some profits every so often. Or do you equally discount the idea of a paper gain?
Jacques Boutet says
The above discussion highlights how subjective the calculation of “opportunity cost” can be. Life doesn’t deal off a deck of cards that you can count and lock-in a viable probability model for the immediate future. Life is most easily and effectively managed with a Long View.
Yes, TFB’s procrastination cost him $70. However, given the vagaries of airline pricing, the delay could have easily delivered a $70 discount. As we all know, the concept of a “random walk” down Wall Street also discourages market timing. That said, we have to make decisions, commit resources and live with the consequences….and their opportunity costs. So it goes.
In my view “opportunity cost” must also consider its associated risk factors and reflect a strategy to manage them. I believe an essential part of risk management is to not worry about things you can’t control. You can’t control market rallies or airline ticket pricing. Neither can you control sudden scheduling conflicts (that might incur a ticket change fee) nor what day of the week you get paid (and have enough $$ to buy the ticket). You can only prepare and try to leave yourself as much flexibility as possible to adjust to the things you can’t control.
However, if you insist on obsessing about the day-to-day surprises Life delivers, you need not bother with a Long View. The stress alone will accelerate your journey from this world to the next.
I have heard from those who routinely check fares on the internet that the site remembers you checked earlier and raises the fare in order to scare you into purchasing now before it goes up again. If you check from another computer you will find the original price most of the time.
Harry Sit says
@Random Poster – That story showed a “paper gain” is actually a real gain worth protecting. Therefore a “paper loss” is also a real loss.