The Definition of Opportunity Cost in Art Investing
Masterworks Do you ever wonder about the opportunities you missed? You’re not alone! After all, when dealing with investing, missed opportunities mean more than just a skipped party or a better dinner. In investing, missed opportunities mean missed chances to grow your money.
And those add up over time.
Here’s a simple breakdown of the opportunity cost definition in investing, how to understand it, and what it means for your investing decisions.
Opportunity Cost Definition in Investing
In investing, opportunity cost refers to the potential benefits an individual, investor, or business missed out on by choosing a different investment. Think of it as what else you could have done with your money and how much good it might have done you.
This is a core concept for investing (and life as a whole).
As an investor, opportunity cost means that your investment choices will always have potential future gains or losses. In order to invest successfully, you have to learn how to make the most effective investing choice based on the available information.
How Opportunity Cost Works and How to Calculate It
Anytime you face a financial decision between two or more options, you’re contemplating opportunity cost. You’re always trying to determine the return you’ll get from each option so that you can maximize your outcome.
For example, let’s say you’re weighing a current painting (Painting A) against a potential new painting (Painting B). In both cases, the future value of the stock could go up or down. It can also be trickier than simple 2 + 2 calculations. Painting B could cost twice as much as Painting A, but that doesn’t inherently mean it’s a worse investing decision if it generates better returns. This is when you need to calculate opportunity cost to determine which is the better choice.
There is a simple formula for opportunity cost, which goes like this:
Opportunity cost = (return on best foregone option) – (return on chosen option)
If you’re paying attention, you’ll notice that this isn’t a precise calculation. It’s based on your assumptions of what your potential returns might be, which may not equal your actual returns. There are analytical ways to assess this, but it’s still based on your assumptions.
Also, keep in mind that when you’re calculating potential returns, you shouldn’t just account for flat returns—you should also account for the risk level, which will affect how much you get in return and how likely you are to see those returns.
Key Concepts in Opportunity Cost
When you think about opportunity cost, there are three key concepts you should always remember:
- The law of increasing opportunity cost
- Comparative advantage
- Marginal opportunity cost
The law of increasing opportunity cost states that opportunity cost will go up if you’re producing a good or opt to produce more of it. For one thing, the cost of production goes up, and the higher the costs of not producing a different good.
Comparative advantage is when a company or a whole economy can produce goods or provide services at a lower opportunity cost than competitors.
Marginal opportunity cost is an estimate of the opportunity cost involved in producing a single good. Depending on the conditions, marginal opportunity cost can be higher or lower as you produce more or less goods.
How do these stack up for investing? All the same basic rules apply to investing decisions. Essentially, you’re measuring the relative value of keeping your current investment, including how efficiently it delivers returns compared to a different option.
What Opportunity Cost Means for Art Investors
For investors, it’s important to remember that every decision comes with a tradeoff. The challenge is that you don’t know exactly what the tradeoffs will be or the exact value of your investments. That’s part of investing—taking a risk in order to see returns. But even though you can’t predict exactly what your returns will be, you still need a calculated approach to opportunity cost.
This comes down to implicit and explicit costs.
Explicit costs are the costs you can see. It’s the cost of buying a piece of art, for example, or buying shares in a piece of art when you could have spent the money on something else. Implicit costs aren’t a direct cost to you, but rather the lost opportunity to generate income through the same resources.
Every decision has a lost opportunity, whether we’re talking about art investing or buying a house. One of the key skills involved in investing is figuring out the right decision to maximize your payoff relative to your opportunity cost, since it’s impossible to be in two places at once.
Why Opportunity Cost Matters for Investors
Opportunity cost is incredibly important for investors, particularly when you’re comparing investments of similar risk.
Remember, investment is not gambling. When done correctly, it’s a calculated decision made to pursue your best possible outcome based on the available information. This can often translate to a significant returns gap over time when choosing between seemingly similar investments.
Opportunity cost is also a tool to help you invest with confidence. With art, for example, calculating returns is a tricky business. By examining opportunity costs in advance and doing your best to account for invisible value drivers in the art market, you can invest in an artist market with confidence and keep your attention fixed on your financial goals.
Using Opportunity Cost for Smart Art Investing
We know that the art world is often opaque. And here at Masterworks, we’re on a mission to democratize blue-chip art investing.
That’s why we act as your expert partner in the art world. Our research team partners with Citi Bank and Bank of America to identify high-growth artist markets with the highest potential risk-adjusted returns. Then, our art team gets to work authenticating artwork for purchase. That way, you have the data you need to buy shares in multi-million-dollar art with confidence. Ready to get started? Fill out your membership application today to learn more.
