Tuesday, March 13, 2018

Opportunity costs

Definitions

Opportunity costs can be defined as ”The loss of other alternatives when other alternative is chosen.” Or as ”The value of the choice of a best alternative cost while making a decision.”

Some opportunity costs are easier to understand than others

All the things you do have opportunity costs. You can´t have everything. When you choose something, other possibilities are not available, in the present moment. For example, if you want to work, you cannot watch TV. You always need to compare the alternatives with each other. Opportunity costs can be different than the cost of acquiring things. For example, when you get something for free, your loss comes from lost time, space, effort, etc.

Counting or approximating the cost can be simple or extremely hard. Easy choices like choosing a brand label which costs 1.5$ or a similar product that costs 1$, make counting opportunity costs easy. The opportunity cost of choosing a brand label is 1.5$-1$=0.50$. Simple calculations about opportunity costs are useful tools for everybody. When complexity arises, opportunity costs are harder to calculate. For example, when you think about working over time or spending your time home with your family, opportunity costs are very hard to calculate. Calculations can become harder, when the options are plentiful or each of the two options have several factors that change or are harder to put any value on them. For example, choosing a laptop from different models, brands, and characteristics. In addition to them, you have to consider all the different prices.

If cow had wheels, it would be delivering your milk”

Most opportunity costs have ifs. You have to consider the uncertainty, when you are trying to figure out them. If you are using statistics and/or probabilities, to calculate opportunity costs, you have to understand what you are doing. You cannot rely on averages, when they do not matter. For example, expected payoffs are not always the same as averages. For example, stock indices can give you real 7% of annual return, on average. Comparing this number with saving money and calculating opportunity costs gives you wrong results, when stocks are very expensive or very cheap.

Most often, there are some uncertainty in calculations. And when there is uncertainty, you have to understand the need for margin of safety. Ifs create errors. These errors can be way larger than you think. This is really important, when you are thinking about changes for things that work at least on average. The other opportunity has to be much better than a previous thing. A famous investor John M. Templeton talked about 50% better opportunity before changing an investment vehicle for a better one. I am not saying that you should do the same. 50% better is just an example about investing and about one person. You should figure out your own margins in different situations. They can be larger than you think.

Some instructions for calculations

Keep things simple. The more options you use, the harder the calculations become. You should leave the least probable options away from your calculations. In economics, you only calculate the opportunity costs compared to the second best alternative. This should work with simple options considering money. I wouldn´t use only the second best option all the time, but you figure out what is best for you. You also shouldn´t compare apples with oranges. You can´t calculate or estimate opportunity costs of two totally different options. If you think that you cannot calculate or estimate opportunity costs within fairly easy, forget them, especially, when you are talking about small decisions. Calculating opportunity costs have opportunity costs too.

Sources:

Poor Charlie´s Almanack, Peter Kaufman

Have a nice end of the week!

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