There is no one query that is more integral to the choices of every potential investor than this: what is the Return On Investment (ROI)? This important term tries to directly measure the amount of return on a particular investment, relative to the investment’s costs.
It can help you to evaluate the yields of an ongoing investment – which is useful in helping you decide whether that particular asset is worth keeping, bolstering, or letting go. You can also use ROI to estimate the potential return on an investment opportunity so as to decide if it is worth your time, money, and effort.
ROI is such a commonly-used term nowadays that it no longer refers only to the consideration of a business investment; nowadays, people use it to mean the level of enjoyment they would derive from attending a party, watching a movie, or even taking on a new job. But this kind of common usage doesn’t always mean that everyone who uses the term actually knows how to calculate the ROI of their investments.
It is a key metric for helping you make informed choices for your portfolio, and can be a useful tool in helping you to avoid making impulse investments. Thus, it is in your best interests to understand when ROI is helpful and to find a simple method to use when calculating it.
When is ROI helpful?
ROI can be used to measure the profitability of any type of investment asset, such as whether to buy a stock or to buy into a business. It is best used when comparing different investments of the same type – which means that it is a good way to compare stocks to other stocks, though you might run into some confusion if you try to compare stocks to a property.
The basic formula is fairly simple, but its simplicity itself can cause problems. During the calculation, you have to pay careful attention to make sure that you account for all costs and gains of the investment throughout the time period in which you hold it.
Simply divide the value of the investment asset by your initial investment amount. For example: when calculating the ROI of your shares in a particular stock, the dividend payout is the gain, and the transaction fee is the cost. Of course, if you end up selling your shares, the gain would include dividends received plus profit (or loss) on the selling price.
Meanwhile, the ROI of a rental property must account for the rent amount as a gain, and the other overheads – including property taxes, repairs, and insurance – as costs.
Investopedia has an informative article that walks you through different ways to calculate ROI and interpret it. Below, we will demonstrate one of the simpler calculations to use so that you can get a feel for the type of calculation – without getting lost in the numbers.
ROI is calculated by subtracting the initial cost of the investment from its final value, then dividing this new number by the cost of the investment, and finally multiplying it by 100 to express it as a percentage. Turning the ROI into a percentage is important as it will make it easier to understand and interpret, especially when comparing investment classes.