What’s the difference between opportunity cost, sunk cost and trade-off?
We break it down for you.
In this scenario the opportunity cost is the sacrifice you make by investing in one ETF versus investing in the other. Specifically, opportunity cost is a ratio of what you sacrificed versus what you gained. So for every 1% per year of return you gained from investing in the one ETF, you sacrificed x% per year of return in the other ETF. Rational investors would want to make sure this ratio is less than 1x. If it is greater than 1x then the opportunity costs of sacrificing the alternative are greater than the benefits from the choice that was actually made. Some people mistakenly see this a trade-off, trading one outcome for the other. Economists have a different definition of trade-off and it is important to understand the difference.
Trade-off is most frequently associated with finding the indifference point between two alternatives. As it relates to our scenario above, an investor would be looking at the various risk/return trade-offs between the two investments. This is a very different idea to opportunity costs. Using historical data it is possible to calculate the specific returns and risk associated with each investment opportunity. An investor would then need to consider if the expected return is sufficient to compensate for a specific risk level in each investment. It is in this scenario that the investor faces a specific risk/reward trade-off between the two investment choices.
Another concept that is sometimes confused between opportunity cost and tradeoff is sunk cost. A sunk cost is a specific investment that has already been made and cannot be recovered. In more colloquial terms, it is the idea that “we’ve come this far, we may as well keep going.”
Another area where sunk costs play a role is in business related investment projects. Sometimes businesses are reluctant to abandon a bad project because so much money has already been invested. This is common in technology projects where management has already sunk a specific amount of money into the development of a specific and will continue spending to complete the project even when it is over budget and under-delivering on expectations.
Sunk costs relate to the cost of already being involved in a decision so deeply that it seems too expensive to undo this decision when the reality may in fact be different. This is different from an opportunity cost that looks at the next best thing that was given up by choosing one thing over another.