Return on investment, also known as ROI, is a measurement that helps you understand the profitability of an investment. Every investment involves some risk, and often, your investments will yield a combination of gains and losses. However, when you start investing, the goal is to make more money than you lose — and ROI is the easiest way to gauge the annual returns, or profits, from an investment.
When you understand the ROI of an investment, you can make more informed decisions about which investments are likely to be more worth your attention. You can use the same ROI formula to gauge the profitability of any type of investment and make an apples-to-apples comparison, with an eye toward annual rates of return.
ROI is an easy-to-use metric to determine the benefit of an investment, relative to its cost. Because ROI is simple to determine and versatile enough to apply to various types of investments, it is widely used.
ROI is expressed as a percentage, so it can be used to compare the performance of various types of investments. For example, an investor can easily compare their ROI for an investment in a mutual fund, in a particular stock, and in a real estate investment trust (REIT). By simply determining the ROI for each investment, you can quickly see which one has been most profitable.
Calculating ROI is fairly simple. Basically, to calculate ROI you need to divide the net profit or loss of an investment by its initial cost.
The ROI formula looks like this:
ROI = (Current value of investment – Cost of investment)/Cost of investment
When you apply the ROI formula to a particular investment, the result is expressed as a percentage or ratio. For example, say you invested $1,000 in ABC Company one year ago. Today, you sell all your shares in ABC Company for $1,400. If you wanted to determine the ROI for your investment, you would calculate it like this:
ROI = ($1,400 - $1,000) / $1,400
For this investment, your ROI would be roughly 29%. That figure isn’t exact because it doesn’t include capital gains taxes and the fees that were involved in buying or selling your shares. For a more realistic calculation, let’s say you paid a $10 fee to buy the stock, a $10 fee to sell it, and 15% capital gains tax on the $400 annual return. In that case, you would need to add $80 to the cost of the investment ($20 for trade fees and $60 for capital gains tax). Here’s how your calculation would look now:
ROI = ($1,400 - $1,080) / $1,400
After including all the costs involved in the investment, you end up with a more realistic capital gains figure of 23%. You can use that percentage figure to compare a wide variety of different types of investments. Even if the investments are across different asset classes or currencies, the ROI expressed as a percentage makes it easy to compare them and figure out which one delivers the greatest return.
There is no set rule of thumb for figuring out what is a good ROI, as it depends on your expectations, your risk tolerance, your timeline, your other investments, and the other investing opportunities that are available to you.
For example, if you have a low tolerance for risk, you may be satisfied with a lower ROI in exchange for taking less risk. But if you’re willing to accept more risk, you may expect a higher ROI from that riskier investment.
In general, a 7% ROI is considered good for a stock investment. That is about the average annual return of the S&P 500. Many experts use this index as a benchmark for their investments because of the diversity of the companies it represents. If your stock investments can achieve about the same average annual returns as the S&P 500 index, that is widely considered an acceptable annual ROI.
If the ROI of an investment is positive, the investment may be worth considering. But if other investment opportunities are available that have higher ROIs, you may want to compare the investments more closely. It’s typical to avoid investments with negative ROIs, which means they resulted in a net loss.
However, a general assumption doesn’t always hold true for every individual investor. Instead of considering others’ ideas about a good ROI, it’s best to think about the ROI that would actually be good for you and your own financial and investing situation. To determine the ROI that is good for you, think about:
How much risk can you afford?
What else could you do with this money if you didn’t make this investment?
What would happen if you lost the money you are planning to invest?
The bottom line is that a “good” ROI varies from one investor to another. For a person who can’t afford to lose their money, an annual ROI of 5% with very little risk could be good. But for a person who has the opportunity to make a different investment that will earn 20% annual ROI, that 5% ROI investment may not look appealing. If you have very little cash flow and need the money back from your investment quickly, a good ROI may be 4% within a year rather than 12% over three years.
Using the ROI metric can be helpful for determining the profitability of an investment, but it does have limitations. For instance, ROI measures only the payoff of an investment relative to its costs; it does not consider the passage of time, or how long you held the investment to earn that return.
Because ROI does not include timing in its measurement, it cannot compute the opportunity costs of an investment. That is, while your money is tied up in a particular investment, you are missing the opportunity of investing that money in other assets. ROI strictly focuses on the costs and returns of a particular investment and does not take into account the costs of lost opportunities.
Also, ROI does not include any measurement of risk. If you see that an investment has a 15% annual ROI, that might be tempting. But the ROI calculation does not provide any indication of the likelihood of that return in the future. As a result, investors must be careful when selecting investments solely based on an ROI formula.
ROI is an important metric for investors because it offers a relatively simple formula for determining the profitability of an investment. Because ROI is expressed as a percentage, it provides an easy way to compare from a variety of different types of investment options.
However, ROI should not be the only metric that investors use to make decisions about which opportunities to pursue. That’s because ROI does not account for risk or time horizon, and it requires you to measure all costs exactly. While using ROI is a really good place to start when evaluating the value of an investment, it should not be the only metric you use to determine whether to pursue an investment opportunity. Because ROI does not account for risk or the passage of time or the degree of risk involved in an investment, it should be used in conjunction with other investment metrics as well.
If you’re just getting started with investing, understanding ROI is important for gauging the value of various investments. As you become more familiar with investing and understand your own appetite for risk and investment expectations, you’ll become more comfortable using ROI as one tool for evaluating potential investments and gauging your investing progress.
The views expressed are generalized and may not be appropriate for all investors. Investing involves risk, including the loss of principal. Carefully consider your financial situation, including investment objective, time horizon, risk tolerance, and fees prior to making any investment decisions.