Sunday, November 8, 2020

How to Calculate Return on Investment (ROI)

 

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 managementposition 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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