Opportunity cost

The opportunity cost of an investment is the return you could have got if you'd put your money elsewhere.

The opportunity cost of an investment is the return you could have got if you'd put your money elsewhere.

For example, if I put £1,000 in shares, I give up the chance to invest in government bonds (gilts). Gilts offer a lower but safer return, reflecting the fact that the government is less likely to go bust than a firm. This is the return I sacrifice (the 'opportunity cost') if my shares then fall.

By extension, if I am willing to invest in shares at all, I should expect to make more than I could earn from gilts. This is the 'equity risk premium'. So if a medium-term gilt yields 3%, my expected return on shares might be more like 8%. That's the opportunity cost of not buying gilts (a 3% return) plus a 5% premium.

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