**How to Calculate Return on Investment
(ROI)**

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.

**Introduction**

Whether
you're day trading, swing trading, or a long-term investor, you
should always measure your performance. Otherwise, how would you know if you're
doing well? One of the great benefits of trading is that you can rigorously
measure how you're doing with objective metrics. This can greatly help
eliminate emotional and cognitive biases.

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.

We've
discussed risk management, position sizing, and
setting a stop-loss. But how do you measure the performance of your investments? And how can you compare the
performance of multiple investments? This is where the ROI calculation comes in
handy. In this article, we'll discuss how to calculate return on investment
(ROI).

**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.

Just purely looking at
ROI won't give you insights into its safety, so you should consider other
metrics as well. You could start by calculating the risk/reward ratio for each trade and investment. This way, you
can get a better picture of the quality of each bet. In addition, some stock
market analysts may also consider other factors when evaluating potential
investments. These can include cash flows, interest rates, capital gains tax,
return on equity (ROE), and more.

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