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Understanding Opportunity Cost

“Two roads diverged in a wood, and I – I took the one less traveled by, and that has made all the difference.” – Robert FrostRobert Frost’s famous line from his poem is an eloquent way of talking about opportunity cost. Opportunity cost is a most important concept. Opportunity cost is the true way to measure the cost of something you are doing.The true cost of something is what you give up to get it. This includes not only the money spent in buying (or doing) the something, but also the economic benefits (utility) that you did without because you bought (or did) that particular something and thus can no longer buy (or do) something else.

Opportunity cost factors into every decision you make. Consider the cost of buying a fabulous new car. The cost is not just the initial outlay—it includes what it will cost to run it, maintain and repair it, insure it, and what you have to give up in order to have it.Leaders know that many situations and decisions in business involve risk, and there is an opportunity cost associated with every decision you make. An opportunity cost is the cost of a missed opportunity. This is usually defined in terms of money, but it may also be considered in terms of time, person-hours, or any other finite resource.

Great leaders understand the consequences of their decisions before making them. Economics and finance are not the only things to think about, however. Costs should be measured based on your own personal feelings and values. For example, if you like to cook, you shouldn't become a doctor instead of a chef simply because doctors earn more money than chefs. That is an opportunity cost that is way too much.Besides that, you can drive yourself nuts thinking about all the things that could have happened if you had made different choices. What if you hadn't gone to the party where you met your spouse? What if you had gone to a different school and met different people who are now multi-billionaire technology giants? You could go insane trying to figure out all of the things you could have done. You must make decisions. The goal of studying opportunity cost is not to make yourself constantly second guess your actions or strategy, but to make sure you are aware that your choices do have consequences.Think of these people and how they have changed our world:

  • What if Walt Disney had never started animating?

  • What if Elton John had never composed songs?

  • What if Warren Buffett had given up when he was rejected from Harvard Business School?

  • What if Thomas Edison had stopped working on the light bulb when he failed the first few thousand times?

  • What if Michael Jordan had stopped playing basketball when he was cut from his high school team?

  • What if Steve Jobs had never returned to Apple to lead its resurgence, fundamentally reshaping the future of technology?

That would be an amazing pile of opportunity cost.But people are sometimes so frightened that they do nothing. Doing nothing is a choice too. Sometimes we are so overwhelmed by choices and information, we are paralyzedand can’t decide so we just stay put. This can have terrible consequences. Doing nothing has an opportunity cost.Unfortunately, people who are faced with complicated and multifaceted investment decisions often choose to do nothing. By not acting, they can avoid the risks altogether, even though they also forfeit the benefits of a calculated, wise investment. Careful consideration of options, opportunities, and risks are important. However, don’t get so wrapped up in research that you never act. It is easy to become so aware of the potential risks that you become afraid to make an investment and put your money on the line.

So how do you get over that paralyzing feeling? Ask yourself three questions.

Money - What else could you do with this money? Perhaps you could allocate your funds to training or education rather than an immediate investment opportunity, and maximize your long-term financial gains.

Time - What else could you do with this time? In some cases, your time is even more valuable than your money. Make sure you understand how you will have to spend your time and the value of time management when you make a personal or professional decision.

Effort - Where else could you spend this effort? If a certain decision is likely to provide you with a significant result, but it will require an immense amount of effort to monitor and supervise, it might not be worth it in the long run. You might decide that your energy is better spent on your current professional endeavors.By answering those three questions, you can make the best choice and minimize the impact of opportunity cost. Opportunity cost is another way of saying trade off. Is trade off a trade up? In other words, is the juice worth the squeeze?

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