Tag: gain

  • ROI or Return On Investment – The Efficiency Of Investment

    ROI or Return On Investment – The Efficiency Of Investment

    ROI or Return On Investment
    ROI is a useful method to compare different investment opportunities, but it has limits

    ROI or Return on Investment estimates the gain or loss created on an investment related to the amount of money invested. Investors use ROI to compare the performance of different investments or to compare a company’s profitabilities. In essence, the Return on Investment measures the gain or loss of some investment relative to the capital invested. 

    The main goal of investing is profit, so it’s essential to seek investments that give the biggest potential return. ROI or Return on investment is the ratio of profitability that measures how big return will be on some investment relative to the costs. Commonly, you can see ROI as a percentage. This measure is very important when you want to evaluate an investment.

    Also, ROI is a valuable tool when you want to compare several investment opportunities. 

    For example, you have some dilemma in which company to invest in because you saw several interesting options. And it seems that all of them are good. What are you going to do? Of course, you are going to estimate the efficiency of each company particularly to reveal which one is able to generate more profits.

    How to calculate ROI or Return on Investment?

    To calculate ROI just divide the net return on investment by the cost of investment and multiply the result by 100 since ROI is expressed in percentages.

    The formula looks like this:

    ROI = (Net Return / Cost of Investment) x 100

    For example, you invested $10.000 in some stock a year ago. Now you sold it for $15.000. Let’s calculate the return on your investment.

    $15.000 – $10.000 = $5.000
    Your net return is $5.000. Let’s go further by following the formula. 

    ROI = ($5.000/$10.000) x 100 = 50%
    And you find ROI on your investment is 50%. The calculation is quite simple.
    To calculate ROI you can use this formula too:

    ROI = ((Final Value of Investment – Initial Value of Investment)/Cost of Investment)) x 100%

    Calculate ROI for different investments

    The basic ROI formula reveals how much an investment generated overall. But, if you want to compare ROI from several investments, you will need to take into consideration the amount of time needed for some investment do give you return.

    For example, let’s say you want to compare the ROI from two separate investments. Let’s do this using our previous example. The capital invested is $10.000. One year later you sold the shares for $15.000 and gained $5.000, so the ROI is 50%.

    But two years prior to this purchasing you bought some stake of shares of the other company and you invested, let’s say, the same amount of $10.000. After 3 years of holding it, you sold these shares for $16.000.

    Let’s calculate the ROI for this investment.

    ($6.000 / $10.000) x 100% = 60%

    ROI is 60%. Great! 

    Wait for a moment. It just seems that this second investment yielded a higher ROI. You had to hold this investment 3 years to generate a return of 60%. In other words, time matters. 

    The first investment generated 50% after one year, the second returned more but after 3 years. It generated 60% which means the annual return of just 20%. When you compare these two investments and their annual yields it’s clear that you made a better investment decision in the first example. To put this simply, even if you have a better overall return on some investment think about the amount of time you needed to reach it. The annual ROI is what will tell you about how good your investment is. Do it for each investment in your portfolio and you’ll figure out the winners.

    The other methods to calculate the return

    There are more precise methods to calculate return on investment. ROI isn’t the only one and has its limits. 

    To be honest, calculating ROI is an excellent way to compare investment chances. But one of the limitations of ROI is the lack of risk estimation. ROI formula doesn’t factor it into consideration. The risk estimation is very important particularly when you need to calculate actual returns. ROI is good to show you a potential return on your investment. But will it tell you how much you can lose? Not necessarily. 

    You must know that higher returns are in tight connection with more risk. The Higher returns, the more risk involved. This is particularly true for stocks. They have higher returns than bonds, for example, but at the same time, they are riskier. 

    Almost the same is for companies. When the company has a lower credit rating, it will offer a higher interest rate on bonds to balance the investors’ risk. 

    For example, you purchased the bonds from a company described above. It offered you much higher returns on its bonds and you might think it is a better opportunity than some company with good credit rating. And you made a calculation and saw ROI of, let’s say, 60% after one year. So, let’s see why it wasn’t a smart decision. What will you do if that company fails to pay interest rates? Well, you’ll end up literally without any returns. 

    Can you see where the point is? ROI is great but it measures only the potential return on investment, not actual. For proper decision, you will need a Real Rate of Return that takes into account inflation, taxes, and other factors. Also, the Net Present Value (NPV) is more suitable for investors like to estimate returns in the far future.

    This metric is helpful

    As most important, it is a simple metric, and easy to calculate and understand. You cannot misunderstand it. Moreover, it is a general measure of profitability applied everywhere all over the world. When you see that some investment has an ROI of 30% that is the same in the US or Europe or Africa. Thanks to its simplicity ROI is good enough for estimation the efficiency of a single investment or to compare the returns from several different investments.

    What is a good ROI?

    Investment returns must beat inflation, taxes, and fees because no one would like to hold an average investment. We all need excellent investments. That’s the whole wisdom, to earn a higher rate of return on investments. 

    A good ROI depends on the investment. The truth is that you have to keep expectations rational. For example, if you are expecting to gain 20% from blue-chips over the next 10 years, we have to say your expectations are pretty much unrealistic. It isn’t going to happen. Whoever promises you that, plays on your inexperience. For instance, the stock market’s average annual return is about 10%, for more aggressive investors it was about 15% per year. And it was almost the same for the last 100 years. Take it or leave it. Whoever promises you a moon is lying or trying to fraud you. 

    Bottom line

    ROI or Return on Investment calculation isn’t an accurate metric but it is a good way to reach the approximate figures. You can always expect some deviation or error in ROI calculation.
    ROI is rated as the single most significant measure of the efficiency of an investment. A better ROI means that investment has satisfying results. When you want to compare the ROI of different investments it is important to compare the companies from the same or similar sectors.
    This metric is very connected to what happened in the recent past. You have to follow a simple rule of thumb: the lower the recent returns, the higher the future returns. And vice versa.

  • The Average Stock Market Return

    The Average Stock Market Return

    The Average Stock Market Return
    The stock market average return of 10% is exactly that – an average, while the returns for any particular year may be lower or higher.

    The average stock market return was about 10% annual for the past almost 100 years. But when we take a look at any year particularly we could notice that the returns weren’t always average. And that is the truth about the average stock market return, it is average rarely.

    Historical data shows the average stock market return is 10% but when you look at year-to-year it can vary. For example, this rate should be reduced by inflation. Inflation can vary too let’s say from 2% to 3% which is a regular rate. 

    But when we talk about investing and investors we usually think about long-term investments. To be honest, the stock market likes long-term investors. They are keeping their investments five or more years.

    Keep in mind: the stock market’s returns aren’t average and could be far from average. For example, over the past 80 years, you could find that the average stock market return was from 8% to 12% only several times. Due to the volatility of the stock markets, most of the time the average stock market return was higher or lower. So, returns can be positive even when the market is volatile but the average stock market return will not rise every year. Sometimes it will be lower sometimes higher.

    What is the average stock market return? 

    The average stock market return actually is about 7%. If we take into account the periods of highs, for example, the 1950s the returns were up to 16%. But we had the negative returns of 3% in the 2000s.

    For example, from 1998 to 2018, we had an average stock market return of 6.88%. The lower return came from the enormous loss in the market in 2008. 

    But, over the last 50 years, the average stock market return was 10.09%.

    The stats may help here, the Dow Jones – by May 25, 2018, the average annual return was 5.42%. On January 6, 2012, a 25-year period ended with an average return of 7.55% per year. But if we look at data from the beginning of 20 century, the average stock market return was around 4.3% respectively.

    On the other hand, the S&P 500 index had average returns from 1957 through the end of 2018 about 7.96%. But, the average annual return from its inception in 1926 through the end of 2018 was about 10%. Last year, 2019 was great with a return of 30.43%. If we include dividend reinvestment, the S&P 500 return was 33.07%.

    How to calculate the average return on stocks?

    The average return on your stocks’ portfolio should reveal to you how well your investments have run in a particular period. This can also help you to predict future returns. Remember, this measure isn’t the annual compound growth rate.

    So, to calculate the average return on stocks you will need to calculate the return for each period. The next step is to add returns together and divide the result by the number of periods. That’s how you will get the average stock return.

    Calculate the average rate of return

    Firstly, what is the average rate of return?
    It is the percentage rate of return that is expected on an investment but compared to the initial cost. 

    The formula is quite simple. Divide the average annual net earnings after taxes or return on the investment to get the average annual net earnings and then display in percentage.

    The average rate of return formula = (Average Annual Net Earnings – Taxes) / Initial investment x 100%

    Here is the explanation of what we did:

    Firstly, determine the earnings from stock for a particular period, let’s say 10 years. Now, you have to calculate the average annual return. Do that by dividing the total earnings after 10 years by the number of years.

    Further, if you have a one-time investment, find the initial investment in the stock. If you want to calculate for regular stock investments, take the average investment over life.

    And finally, divide the average annual return by initial investment in the stock. 

    Also, you can do all of this and get the same result if you divide the average annual return by average investment in the stock but expressed in percentage.

    Let’s take the example of a stock that is likely to generate returns of 10% per year after taxes and for a period of 3 years.

    The initial investment       $10.000
    First-year’s net earnings   $1.000
    Second-year net earning  $2.100
    Third-year net earnings    $3.310

    Use formula

    The average rate of return formula = (Average Annual Net Earnings – Taxes) / Initial investment x 100%

    After 3 years your initial investment will be increased by 64% or you will have $6.420 more in your account.

    What does this mean for investors?

    As always, computing dividends is important and you have to account for them. If you reinvested received dividends, even better. That’s compounding on compounding!

    The truth be told, those who have stayed invested in stocks have largely been rewarded.

    The understanding of the concept of the average rate of return is important because investors make decisions based on the possible amount of return expected from an investment. Based on the average rate of return, you can decide will you enter into an investment or not. Moreover, the return is used for ranking the stocks and ultimately you will choose per the ranking and include them in the portfolio.

    In a few words, the higher the return, the better is the stock.

    But let’s examine one different case of the average stock market return. 

    Let’s say your initial investment is also $10.000 but (this isn’t easy to say) in the first year you lost 20% of the initial investment. That’s bad news. But in the second year, you gained 20% of the initial investment. Oh, how nice it is!

    Yes, nice but your gain is zero.

    (-20+20) = 0

    What do you think? Do you still have your $10.000? Things never move in that way.

    Here is why.

    When you lose 20% of your initial investment you ended up with $8.000. Right? That amount became the amount of your investment. On that amount, you gained 20% or $1.600. So, after two years you have $9.600 in your hands and you are short for $400 compared to your initial investment of $10.000. You lose money and your return isn’t zero. Your return is minus and you will need more gains in bigger percentages to cover that loss.

    The stock market average return isn’t misleading. That is how you have to calculate it.

    Or to calculate CAGR.

    Bottom line

    This means that investors MUST have a financial plan and investing strategy.
    There are no guarantees for big gains in the stock market and never were. The average return of 7% or 10%  is great if you are a long-term investor. It is reasonable to expect a good return on the current stock markets if you reduce your enthusiasm when the good times come.
    That’s nice, you’re making money. But, when stocks are jumping, remember that not so good time may come. Especially keep this in your mind over the bull market cycle.
    You can get the average return only if you buy and hold but not if you trade frequently. Even a few percent per year can produce nice gain over the years.