- Return on investment (ROI) is a metric used to assess the performance of a particular investment.
- ROI is expressed as a percentage and can be calculated using a simple ROI or annualized ROI equation.
- Looking at ROI doesn’t take into account risk tolerance or time and may not show all costs.
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Return on investment (ROI) is a financial ratio that’s used to measure the profitability of an investment relative to its costs and is expressed as a percentage. When you consider investing in anything, you often hear about getting a “return on investment” but may wonder what that really means and how it works. Here’s what to consider with ROI.
Why ROI matters
When you invest, whether in the stock market or in your business, your goal is to earn money and get a return on your investment. You put up cash anticipating that what you put in offers an even greater ROI.
“ROI is expressed as a percentage and is calculated by subtracting the cost of an investment from its current value and then dividing by the cost,” explains Nicole Tanenbaum, partner and chief investment strategist at Chequers Financial Management in San Francisco. “It is a simple and straightforward formula that can be easily used to calculate the rough profitability of nearly any investment, from stock investments to business projects to real estate transactions.”
As an investor, it’s important to assess ROI as a financial metric to see how your particular investments are doing. In basic terms, are you getting more out than you put in? Or are your investments costing you, in the form of negative returns?
ROI goes hand in hand with risk and reward, meaning that with greater risks comes the potential for even higher rewards.
According to Investor.gov, a website run by the Securities and Exchange Commission (SEC), for many decades stocks have had the highest average rate of return but also tend to come with the highest risk.
ROI matters because it’s an easy-to-use metric to evaluate an investment’s performance. Expressed as a percentage, the higher the number, the greater the return.
If an investment doesn’t have a solid ROI, it may be a good time to rebalance your portfolio and sell off some assets that aren’t doing well. However, it’s important to consider any transaction costs and affects on your overall returns in the long run.
How to calculate ROI
In order to calculate ROI, you can use the following formula:
Let’s break down the pieces of the ROI formula.
- Net investment gain refers to the net return you get with an investment, after considering costs already put in.
- The cost of investment is the total amount of money you’ve put in a particular investment.
To calculate ROI, you take the net investment gain and divide it by the cost of investment and multiply it by 100 (this converts it to a percentage).
For example, let’s say you put an initial investment of $US10,000 ($AU13,479) into a company’s stock. Then you decide to sell your shares three years later for $US12,000 ($AU16,175).
Here’s the simple ROI formula in this case:
ROI = ($US12,000 ($AU16,175) – $US10,000 ($AU13,479)) / $US10,000 ($AU13,479)
In other words, you take the final sale of $US12,000 ($AU16,175) and subtract the initial investment of $US10,000 ($AU13,479) which gets you a net investment gain of $US2,000 ($AU2,696).
You then take that number and divide by the cost of investment.
ROI = $US2,000 ($AU2,696)/$US10,000 ($AU13,479) = 0.2
The last part of the equation is to multiply the decimal by 100 to get the percentage.
0.2 X 100 = 20%.
This simple ROI formula is pretty standard when evaluating returns. But the drawback is that it doesn’t take into account the amount of time you held the investments or any opportunity cost.
Annualized ROI can offer more nuance in regards to how long you’ve held an investment and offer a more accurate ROI. Here’s the annualized ROI formula for our example:
A= (12,000/$US10,000 ($AU13,479)) (⅓) -1
A= (1.2) (⅓) -1
As you can see, the simple ROI vs annualized ROI numbers are quite different. Looking at the annualized ROI can offer greater insight into an investment’s performance if you’ve held it for a good chunk of time.
It’s also important to note the difference between a realized gain and unrealized gain.
- A realized gain is the total you gain or profit from an investment that you actually sell. In that case, you’d want to use net income as part of the net investment gain and include any transaction costs, fees, etc.
- An unrealized gain is a gain “on paper.” In other words, it reflects an increase in value but since it’s not actually sold, it’s unrealized. In this scenario, you’d take what your current investment is worth to calculate the net investment gain.
Pros and cons of ROI
While evaluating ROI is a good way to measure performance, there are some limitations, especially when it comes to the simple ROI formula. Here are pros and cons of ROI:
You want to evaluate the pros and cons and know where the ROI metric can fall short.
“ROI can be a useful tool in comparing performance across multiple investments. However, it is important to understand that ROI does not take into account the overall time frame of an investment, or how long it took to generate the overall profit from initial purchase to eventual sale,” explains Tanenbaum.
Time is a key consideration when evaluating the true ROI of a particular investment.
“Time is a factor which should always be considered when evaluating and comparing relative performance across investments,” says Tanenbaum. “Even if an investment earns a higher profit based on its ROI, the longer the time to realization, the less efficient the investment. Therefore, ROI should be used in tandem with other performance metrics such as the rate of return, which takes time and efficiency into consideration.”
Average ROI in the stock market
The reason investing is better than keeping money in a savings account is that the possibility for a higher return is much greater. Savings interest rates have been abysmally low, but the stock market historically has offered good returns over time.
According to the SEC, the stock market has provided annual returns of about 10%, or 6% to 7% when adjusting for the impact of inflation.
Some returns are much greater depending on the type of investment and the timeframe.
“On average, the S&P 500 Stock Index has generated an ROI of about 10% per year over time, but when looking at ROI across industries, they can vary greatly, with higher growth segments generating average an ROI that’s well above 10%, and more defensive industries generating single digits or in some cases, negative ROI,” notes Tanenbaum.
Aside from evaluating ROI, remember to account for “realized” vs. “unrealized” gains as well. This is also important for losses, too. So if the stock market is tanking, you don’t necessarily need to take any action because the loss is “unrealized” until you sell. If you sell at a loss, that’s final. But if you stay in the game, you could recover in the long-term.
The financial takeaway
Return on investment is a commonly used metric to evaluate investments and business decisions. Ideally, your ROI will be positive and growing over time, however it’s possible to get negative returns as well.
ROI can help you decide where to invest and whether you should sell or hold onto assets you already own.While the ROI percentage is useful, it’s important to understand its limitations when evaluating overall risk and time horizon.
Additionally, it’s important to understand the nuances between simple ROI vs. annualized ROI. You also want to be clear on total costs such as transaction fees, taxes, and more, so you’re getting a clearer picture on your actual return on investment.