Return on Investment or ROI, measures the profitability of an investment, for every amount you put in, what profit can you expect.
Return on investment is a measure practiced to estimate the efficiency of your investment. Also, you can use it to compare the efficiency of different investments. ROI seeks to measure the volume of return on investment in comparison to the costs. So, to calculate ROI, you have to divide the return of your investment by the cost. The result will be displayed in a percentage or a ratio.
How to Calculate Return On Investment
ROI formula is:
ROI = (Current value of investment – the cost of investment)/cost of investment
Compounding interest sounds like alchemy for many new investors, but ROI is true magic. Particularly when your money rises each year.
Let’s say you invest $2,000 at 5% interest. You’ll have $3,500 in interest after 15 years. Your initial capital would be grown by $1,500 of interest. But if you invest at a 5% annual compound interest, you will have about $4,158.
But where is the magic?
The magic comes now. What if you can earn a higher rate of return?
What if you invest at 8% or 10%? This can be really important because it is your money and you would like to watch it grow.
True magic lies in math.
Let’s say you have an investment goal and also, you know how long you want to hold your investment. For example, you would like to sell some of your stocks after 2 years. Assume you invested $2,000 in the stock. And you did that. You sold your stock for, let’s say, $3,000. Great! You made $1,000 in profit. That is 50% of return which is amazing if you want to calculate it quick and dirty, and incorrectly. But, you need to factor in your liabilities and annual inflation rate to calculate the real return on investment. Okay, you have to pay a capital gain taxes, for example, it is $150, so you ended at $2,850 which is still good. Yes, your return will not be 50% it is 42.5% after you pay capital gain taxes. Oh, wait! Where is the inflation? Yes, you have to calculate the inflation over those two years. Let’s say the inflation rate is 2.5%.
$2,850/(1.025×1.025) = $2,713
Your real value return will be 35.65%. It is less than 50% of return what you may be expected but it’s still good.
It was a bit complicated but correct, which is the most important. And it is for two years. Do your own math for longer periods.
Several things you have to keep in mind.
A good return on stocks has to surpass inflation, taxes, and fees. Only in that way, you’ll be able to build your wealth.
Use ROI to compare investments even if they’re not related. It isn’t the same if you are buying blue-chip stock or small-cap. In short, everything is different. But, if you compare only ROI may provide you a clear insight into where you want to direct.
ROI can be used in combination with the rate of return, which takes into account the time frame, which we did. You can use a net present value or NPV, which we did to calculate the real rate of return.
The usual return on investment for the majority of investors is about 2-3%. It isn’t great. But if you keep your money in a bank account you will have a negative return, after you factor and pay all taxes and inflation.
A good return on investment is 10-12% per year
You can beat the market. That is everyone’s goal, right?
But if you expect to earn 15% or 20% – it’s not going to happen. Or it will happen very rare. Don’t believe in false promises, they are counting on your lack of experience. If you build your financial security on bad premises you will end in a risky field. You may lose all your capital. If you have a more conservative approach to investments you will have a less stressful experience. Investing should give you certainty.
ROI is a popular measure due to its simplicity and versatility. Typically, use ROI as a simple measure of your investment’s profitability. Use the ROI on a stock investment. The calculation isn’t difficult. It is easy to understand. If your investment’s ROI is net positive, it is good. Avoid negative ROI, it is a signal of a net loss.