What It Is:
Opportunity cost refers to the value forgone in order to make one particular investment instead of another.
How It Works/Example:
For example, let's assume you have $15,000 that you could either invest in Company XYZ stock or put toward a graduate degree. You choose the stock. The opportunity cost in this situation is the increased lifetime earnings that may have resulted from getting the graduate degree -- that is, you choose to forgo the increase in earnings when you use the money to buy stock instead.
Here's another example. Let's say you have $15,000 and your choice is to either buy shares of Company XYZ or leave the money in a CD that earns only 5% per year. If the Company XYZ stock returns 10%, you've benefited from your decision because the alternative would have been less profitable. However, if Company XYZ returns 2% when you could have had 5% from the CD, then your opportunity cost is (5% - 2% = 3%).
Why It Matters:
Opportunity cost is all about the most basic of economic concepts: trade-offs. It's a notion inherent in almost every decision of daily life and of investing: if you make a choice, you forgo the other options for now. And what's been given up can sometimes turn out to have been the wiser choice, which is why opportunity cost is best measured in hindsight -- after all, it is impossible to know the end outcome of any investment.