An investor cannot evaluate any investment, whether it's a stock, bond, rental property, collectible or option, without first understanding how to calculate return on investment (ROI). This calculation serves as the base from which all informed investment decisions are made and, although the calculation remains constant, there are unique variables that different types of investment bring to the equation. In this article, we'll cover the basics of ROI and some of the factors to consider when using it in your investment decisions.
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On paper, ROI could not be simpler. To calculate it, you simply take the gain of an investment, subtract the cost of the investment, and divide the total by the cost of the investment. Or:
ROI = (Gains – Cost)/Cost
Investing in Joe's Pizza
For example, if you buy 20 shares of Joe's Pizza for $10 a share, your investment cost is $200. If you sell those shares for $250, then your ROI is ($250-200)/$200 for a total of 0.25 or 25%. This can be confirmed by taking the cost of $200 and multiplying by 1.25, yielding $250.
There are a couple different ways to think about this. The popular one is to picture each dollar invested in this stock paying 25 cents to you. Putting more money in the stock will result in a larger total payout, but it won't increase the ROI. The ROI will be 25% whether $200 grows to $250, $2 grows to $2.50, or $200,000 grows to $250,000. (For more examples of the ROI calculation, take a look at the How To Calculate ROI Video.)
I Just Want the Truth!
Because it is a percentage, ROI can clear up some of the confusion caused by just looking at dollar value returns. Imagine two of your friends, Diane and Sean are telling you about their investments. Diane made $100 investing in options and Sean made $5,000 investing in real estate. Both these numbers will be their return – their profits after costs have been subtracted. With only that information, most people would assume that Sean's investment is the better one. However, without understanding the costs of the investment, we can't make any accurate conclusions about the return.
What if Sean's costs were $400,000 and Diane's were only $50? This would mean Sean's ROI is 1.25% while Diane's is 200%, a clear win for Diane. The dollar value of the return is meaningless without considering the cost of the investment. For this reason, the costs of an investment, both initial and ongoing, are an essential piece of information for any investor. (Learn more about ROI and other ways to value investments; read our Financial Ratio Tutorial.)
ROI and the Investment Rainbow
The ROI calculation remains the same for every type of investment. The variation, and the danger for investors, comes in how costs and returns are accounted for. Here are some commonly mishandled investments.
- Real Estate
Real estate can create returns in two ways, rental income and appreciation. Rental income simply has to be added to the gains as it is realized. Costs, however, come from many different sources. There is the initial purchase cost, taxes, insurance and upkeep.
When people talk about making a 200% return selling their home, they are often making the error of simply using the purchase price and sale price of their while ignoring all the costs in the middle. Or, if it is an investment property, they may be accounting for the rental income and appreciation properly, but neglecting insurance costs, taxes and that new water heater, etc.
Real estate can be an excellent and profitable investment, but the projected ROI on these investments is frequently exaggerated.
Stocks are prey to the same type of omission as real estate. More often than not, investors fail to keep track of their transaction costs. If you make a $100 gain but forget the $20 you paid buying the stock and another $20 selling, then your ROI is grossly inflated. As with rental income, dividend payouts should be added back into the gain column when you want to calculate the ROI.
Collectibles like the Honus Wagner card, Action Comics #1 and the 1933 Double Eagle can sell for millions, making for astronomical ROIs when compared to their original prices. However, collectibles are rarely purchased at their original prices and, depending on the type, have high insurance and maintenance costs that cut the true ROI down to size.
- Leveraged Investments
Leveraged investments pose an interesting problem for ROI. Because they allow the initial investment to be multiplied many times over, they can also generate multiple returns. However, in this case, the incredible ROI that some traders make must be tempered by the risks they take. Leveraging an investment dollar to equal two or three dollars works well when the returns are positive, but losses are similarly leveraged in some of these investments.
With plain vanilla options and basic forex accounts, the most a beginning investor will lose is the price of the option or the balance of the forex account if it stops out. However, it is useful – and sobering – to think of it in terms of the capital controlled. If you lose $1,000 on a forex trade leveraged 10 times, that's a $10,000 mistake – even though it thankfully only cost you 10% of that. ROI can't tell the whole story of leveraged investments. The risk-reward tradeoff is the place to start for that lesson.
Moving Beyond ROI
ROI is a simple calculation that tells you the bottom line return of any investment. The operative word, however, is simple. One major factor that doesn't appear in an ROI calculation is time. Imagine investment A with an ROI of 1,000% and investment B with an ROI of 50%. Easy call – put your money in the 1,000% one. But, what if investment A takes 30 years to pay off and investment B pays off in a month? This is when time periods come into play and investors must look to CAGR.
The Bottom Line
ROI is a useful starting point for sizing up any investment. Remember that ROI is a historical measure, meaning it calculates all the past returns. An investment can do very well in the past and still falter in the future. For example, many stocks can yield ROIs of 200-500% during their growth stage and then fall down to the single digits as they mature. If you invested late based on the historical ROI, you will be disappointed. Projected or expected ROIs on an unproven (new) investment are even more uncertain with no data to back it up. For this reason, Investors must learn about other metrics like CAGR, debt to equity, ROE and many others to dig into the numbers making up ROI. (For related reading, take a look at Analyze Investments Quickly With Ratios.)