What is meant by opportunity cost in finance?

Opportunity cost in finance refers to the value of the next best alternative that is forgone when a decision is made. When you choose one investment over another, the opportunity cost is the potential return you could have earned from the alternative investment that you did not choose. Therefore, the cost of missed investment opportunities encapsulates the essence of opportunity cost, as it emphasizes that by selecting one option, you are giving up the opportunity to benefit from another option.

In decision-making, especially in finance, recognizing opportunity costs is crucial because it helps individuals and businesses assess the true cost of their choices. For instance, if an investor decides to invest in a new venture and forgoes an existing stock that has been performing well, the opportunity cost would be the returns that could have been achieved from the stock investment.

This concept encourages careful analysis of potential investments and decisions, allowing for more informed and strategically sound choices in financial planning and management. Understanding opportunity cost is fundamental for optimizing investment returns and resource allocation.