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Return on Investment or ROI is a performance measure used to evaluate the return on an investment relative to the cost of the investment. ROI, let's just first start at the core, why would you even care about ROI, Return On Investment? Because it's going to tell you, what kind of choice did you make? It is a way of just helping you gauge whether or not you're on the right pathway to obtaining whatever goal that you may have. So that's the essence of it, it's kind of holding yourself accountable. Are you making good decisions, or are you making bad decisions? Could you be making maybe even better decisions?
Return on Investment or ROI is one of the simplest calculations in the financial world. It's a ratio, the gain from your investment minus the cost of that investment divided by the total amount you have invested. Now because the gain minus the cost essentially equals the net gain or loss on the investment you could simplify it simply by taking your net gain or loss divided by the total amount you have invested.
AN EXAMPLE OF HOW ROI WORKS:
So, for example, if you invested $10 and got $1 back, that is a 10% ROI.
(1) ROI can be used to assess the profitability and efficiency of an investment and thus make financial decisions.
(2) ROI is easy to calculate and can be applied to all kinds of investments.
(3) ROI helps analysts determine which investment opportunities are preferable to others.
(1) Since ROI is expressed as a percentage and not as a dollar amount, it can clear up confusion in dollar value returns.
Let's compare two investors. Investor A and Investor B. Investor A gains $200 of profit from investing in options. Investor B gains $50,000 from investing in condos. On paper it looks like Investor B made a much better investment, right? Now, let's factor in the costs of their investments and how this affects the return. What if Investor A's options initially cost $50, while Investor B's initially cost $40,000, that would make investor A's ROI 300%, while Investor B's ROI would be 25%. So, while Investor B had more return in dollar values, investor A has the better more profitable and more efficient investment.
(2) The time horizon must also be considered when you want to compare the ROI of two investments.
Let's look at another example. We have two investments. Investment A and Investment B. Investment A has a 20% ROI over three years, while Investment B has a 10% ROI over a 1-year time horizon. To compare these two, we need to adjust the multi-year investment to the same 1 year time horizon. To adjust this we use the formula for multi-year ROI which is equal to 1+x to the power of T -1. In this formula, x is the annualized ROI of the investment which is what we want to calculate and T is the number of periods in the time horizon, periods being one year in this case. Using this formula that would be 20% = 1+x to the power of 3 -1. With some simple algebra, we can rearrange this to reach x = 6.27%. Thus Investment A is a worse investment than Investment B because its 6.27 ROI is lower than investment B's 10% ROI.
ROI can be used for any type of investment. The only variation in investments that must be considered is how costs and profits are accounted for. Below are 2 examples of how ROI can be commonly miscalculated:
• For stocks, investors commonly fail to incorporate transaction costs and dividend payouts into the ROI of stocks. include transaction costs and dividend payouts into the ROI calculation.
• For real estate, investors commonly fail to incorporate rental income, taxes, insurance and upkeep costs in the ROI of real estate.
That being said we want to emphasize that it's incredibly important to calculate all the costs and gains of the investment throughout its entire lifespan. We can't just take the ending value and divide it by the initial cost because we might miss some tributing factory.
Now the real beauty of ROI lies in its simplicity. Typically, the ROI formula is used to calculate one-time gains or losses like the profit from flipping a property or measuring the annual income from a rental property, or for that matter, any other type of business.
Return on investment tells you how efficient an investment is at generating profits for you. It answers the simple question, "How much money can I expect to make back in profit for every dollar I invest?"
When it comes to the advantages outside the obvious benefit of how simple it is using an ROI calculation allows an investor to easily compare two investment opportunities. Suppose you had two investment opportunities and all else was equal. If investment A will yield a 10% return while investment B only yields an 8% return, then you could pretty confidently move forward with investment A knowing that your money is going to work harder for you. But let's face it, okay? The factors involved in two investment opportunities are never equal.
(1) ROI IGNORES TIME: The ROI calculation ignores the factor of time. In the real world, time plays a very important role in your returns. If two different investments, both yield a 10% ROI, but you get your money back within one year with investment A however, you have to wait three years to get it back with investment B then clearly investment A is the better option because you get your money back sooner. But unless you're presented with this information, you wouldn't know this simply by looking at the ROI number alone.
(2) ROI IGNORES RISK: The ROI calculation also ignores risk. Imagine two different investments, both yielding a 10% ROI. One of them is extremely safe while the other is extremely risky. You would choose the safe investment that offers the same return, but again, the ROI formula by itself contains no information about risk.
(3) HUMAN ERRORS ARE IGNORED: Another thing worth mentioning about ROI is that the profit and investment figures are subject to all kinds of human errors, like optimism, omission and false assumptions. Especially when calculating the projected ROI, which is essentially predicting what we hope will happen in the future nobody knows the future, and it's not uncommon for us to have unrealistic or misguided expectations about how the situation will play out. Like any calculation, the result is only as valid as the numbers you input, but in the case of ROI, it's easy to ignore some crucial variables when calculating both your potential profits and your initial investment amount. For every investment you make, it's a good idea to calculate your anticipated ROI.
ROI is just one of several lenses through which to view any prospective investment. You should also consider the time horizon of the investment, the risk, the impact of inflation, the liquidity of the investment and the opportunity cost of investing in one asset over another.
