NASAA Series 65, Uniform Investment Adviser Law ExaminationEconomic Factors and Business InformationMedium
A client is reviewing their investment portfolio and asks their investment adviser about the concept of 'opportunity cost'. Which of the following best exemplifies opportunity cost in an investment decision?
- AThe return foregone by investing in Stock A instead of Stock B, which yielded a higher return.
- BThe decrease in value of an investment due to market volatility.
- CThe commission paid to a broker for executing a trade.
- DThe income tax paid on investment gains.
Show answer & explanationAnswer & explanation
Correct answer: A. The return foregone by investing in Stock A instead of Stock B, which yielded a higher return.
Opportunity cost is the value of the next best alternative that must be foregone when making a choice. In this context, choosing to invest in Stock A means giving up the potential higher return from Stock B, making that foregone return the opportunity cost.
Why the other options are wrong
- B. Market volatility leading to a decrease in value is an investment risk, not an opportunity cost.
- C. Commissions are direct transaction costs, not opportunity costs.
- D. Income tax is a direct cost or reduction of gains, not the value of a foregone alternative.
Opportunity Cost
Opportunity cost is the value of the next best alternative that was not taken when a decision was made.
- A fundamental concept in economics.
- Applies to all decision-making, not just financial.
- Represents a trade-off.
Memory trick: Opportunity Cost is the 'O'ther 'C'hoice you 'G'ave up.