ROI, or return on investment, is the raison d’être for investing. Whether you’re buying into stocks or your education, you do so with the hopes of getting back more than you put in. What you wind up with as a result of your investment is the ROI.
Definition of ROI
The ROI, or return on investment, is typically expressed as a percentage. It’s the net profit, or loss, you get from investing in something. That makes it a straightforward measure of how well an investment performs—or doesn’t.
To figure out ROI, you first need to know how much you paid for an investment initially and how much it’s worth now. The difference between the two numbers is your net profit, which can either be positive (woo hoo!) or negative (wah). And return on investment is the net profit divided by the initial cost. Then, to show it as a percentage, multiply by 100.
Here’s the formula:
ROI = (final value of investment - initial cost of investment) X 100
initial cost of investment
Example of an ROI calculation
For example, if you buy 100 shares of a stock for $10 each, then your initial cost of investment is $1,000. If the value of the stock goes up to $15 a share, the final value of the investment goes up to $1,500 for your shares. That makes the ROI a 50-percent gain.
ROI = ($1,500 - $1,000) X 100 = 50 percent
But if the value of the stock goes down to $5 a share, the final value winds up being just $500, and the ROI is a 50-percent loss.
ROI = ($500 - $1,000) X 100 = -50 percent
How to interpret ROI
The simple, straightforward interpretation: If the final value is greater than the initial cost, the result will be positive. (Winning!) On the other hand, if the final value is less than the initial cost, you wind up with a negative ROI, i.e. a loss.
Of course, real life is rarely so simple and straightforward. You probably have a few more variables to consider when interpreting return on investment. For example, your initial cost needs to include broker fees and other investment charges, on top of the original value of the investment. So if you had to pay, say, $100 in fees in the example above, your total initial cost becomes $1,100. And the 50 percent gain comes down to a 36.4 percent win while the 50 percent loss slips further to a 54.5 percent drop. The lesson: Minimizing your costs helps maximize your ROI.
The other side of the equation might need some adjustments, as well. For example, if your investment pays dividends, you have to add that to its final value. Back to our example, let’s say you get $100 in dividends. So if your investment grows by $5 a share, with dividends, the final value goes up to $1,600, so in going from $1,100 (including fees) to $1,600, your ROI becomes 45.5%. If your investment falls by $5 a share, with the dividends and fees, your return on investment comes to a loss of 45.5 percent.
Another thing to consider: time. Especially if you want to compare different investments—even if it’s your whole portfolio versus a benchmark—you may want to look at annualized ROI, as opposed to total ROI. Here’s the formula:
Annualized ROI = [(1 + ROI)1/n - 1] X 100
*n = number of years the investment is held
Looking at the annualized figures helps ensure you’re making an apples-to-apples comparison between investments. For example, let’s say Stock A boasts an ROI of 50 percent while Stock B posts an ROI of 30 percent. But Stock A’s ROI is over a five-year period while Stock B’s is over three years, making their annualized ROIs 8.5 percent and 9.1 percent, respectively. That makes Stock B look more attractive than if you’d only considered overall return on investment.
Benefits and limitations of the ROI formula
Simple to use
Even with all the various details to consider, the ROI formula is relatively simple to use and understand. And it works as a measure of profitability for all kinds of investments, whether you’re looking at stocks and bonds or certificates of deposit or even real estate or education.
Just remember that using the ROI formula is a straight-up numbers game. It doesn’t take into account more qualitative factors. For example, when it comes to investing in your education, calculating return on investment might compare how much you spent on tuition and books over the course of your schooling with how much more money you were able to earn each year as a result of your college (or graduate) degree. But it can’t measure how much knowledge you gained or how fulfilling you find your work.
ROI doesn’t account for risk
ROI also doesn’t take into account risk, an important consideration for any investor. Typically, high returns go hand in hand with high risks. So if you’re only looking at ROI when shopping for investments, you may wind up with a pretty risky portfolio. That might be okay, especially if you intend to hold your investments for a long time (read: more than a few years) and you can stomach price drops and volatility (i.e. the up and down price movements of an investment) in the short term. Either way, you need to understand the risks involved with any investment, which means you need to look at more than just ROI.
Still, ROI is an important metric that you need to understand as an investor. It can be a quick and easy way to analyze any investment, assess its potential returns and determine whether it belongs in your portfolio. It can also be a simple measure to help you track the performance of your own portfolio and whether you’re on track to achieve all your financial goals.
Investing involves risk including loss of principal. This article contains the current opinions of the author, but not necessarily those of Acorns. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.