ROI is a way to measure an investment's performance. As you'd expect, it's also a great way to compare the profitability of different investments. Naturally, an investment with a higher ROI is better than an investment with a lower (or negative) ROI. Curious how to measure this for your own portfolio? Let's read on.
So, how is this useful? Well, the human mind tends to build narratives around everything as it tries to make sense of the world. However, you can't "hide" from numbers. If you're producing negative returns, something should be changed in your strategy. Similarly, if you feel like you're doing well but the numbers aren't reflecting that, you're probably a victim of your biases.
What is return on investment (ROI)?
Return on investment (ROI) is a way to measure an investment's performance. It also can be used to compare different investments.
There are multiple ways to calculate returns, and we'll cover some of them in the next chapter. For now, though, it's enough to understand that ROI measures the gains or losses compared to the initial investment. In other words, it's an approximation of an investment's profitability. Compared to the original investment, a positive ROI means profits, and a negative ROI means losses.
ROI calculation applies to not just trading or investment, but any kind of business or purchase. If you plan to open or buy a restaurant, you should do some number crunching first. Would opening it make sense from a financial perspective? Calculating an estimated ROI based on all your projected expenses and returns may help you make a better business decision. If it seems like the business would turn a profit in the end (i.e., have a positive ROI), it may be worth getting it started.
Also, ROI can help evaluate the results of transactions that already happened. For example, let's say you buy an old exotic car for $200,000. You then use it for two years and spend $50,000 on it. Now suppose that the car's price goes up on the market and you can now sell it for $300,000. Not only did you enjoy this car for two years, but it also brought you a sizable return on your investment. How much would that be exactly? Let's find out.
How to calculate return on investment (ROI)
The ROI formula is quite simple. You take the current value of the investment and subtract the original investment cost. Then, you divide this sum by the original cost of the investment.
ROI = (current value - original cost) / original cost
So, how much profit would you make by selling the exotic car?
ROI = (300,000 - 200,000) / 200,000 = 0.5
Your ROI is 0.5. If you multiply it by 100, you get the rate of return (ROR).
0.5 x 100 = 50
This means that you made a 50% gain on your original investment. However, you need to take into account how much was spent on the car to get the full picture. So, let's subtract that from the current value of the car:
300,000 - 50,000 = 250,000
Now, you can calculate ROI while taking into account the expenses:
ROI = (250,000 - 200,000) / 200,000 = 0.25
Your ROI is 0.25 (or 25%). This means that if we multiply your cost of investment ($200,000) by your ROI (0.25), we can find the net profit, which is $50,000.
200,000 x 0.25 = 50,000
The limitations of ROI
So, ROI is very easy to understand and brings a universal measure of profitability. Are there any limitations? Sure.
One of the biggest limitations of ROI is that it doesn't take into account the time period. Why does this matter? Well, time is a crucial factor for investments. There could be other considerations (like liquidity and security), but if an investment brings 0.5 ROI in a year, that's better than 0.5 ROI in five years. This is why you may see some talking about annualized ROI, which represents the investment returns (gains) you could expect over the course of a year.
Still, ROI won't take into account other aspects of an investment. A higher ROI doesn't necessarily mean a better investment. What if you can't find anyone willing to buy your investment and get stuck with it for a long period of time? What if the underlying investment has poor liquidity?
Another factor to consider is risk. An investment might have a very high prospective ROI, but at what cost? If there's a high chance that it goes to zero, or that your funds become inaccessible, then the prospective ROI isn't all that important. Why? The risk of holding this asset for a long time is very high. Sure, the potential reward could also be high, but losing the entire original investment is certainly not what you want.
We've looked at what return on investment (ROI) is and how traders can use it to make more informed investment decisions. The return on investment formula is a core part of tracking the performance of any portfolio, investment, or business.
As we've discussed, ROI isn't the ultimate metric, but it can be useful. You also need to consider opportunity cost, risk/reward ratio, and other factors that may have an impact on your choice between different investment opportunities. As a starting point, however, ROI can be a good barometer to evaluate a potential investment.