The term “ROI” gets thrown around as often in colloquial discussions as it does in financial circles. But what does it actually mean?
Return of Investment (ROI) refers to a measure of an investment’s profitability. It boils down to: what am I getting for what I gave?
In everyday conversation, ROI might get framed as the positive or negative consequences of a certain choice. One could argue, for instance, that the ROI on getting up early on a Saturday to tackle some housework would be the benefit of a clean home and a clear mind once you sit down to relax at night.
In finance, ROI is usually expressed as a statistic. At its most basic level, ROI looks at the percentage of your initial investment lost or gained over a defined period of time.
Don’t let the technical acronym fool you. In its simplest form, the math behind an investment’s ROI is pretty straightforward. To calculate the ROI of an investment, you divide the dollar amount of the profit of the investment by the dollar amount of the cost of the investment and then multiply by 100. Expressed mathematically:
(Profit of investment / Cost of investment) * 100
For example, let’s imagine you invested $10,000 in the stock of a company. In a massive turn of luck, you’re able to sell it a year later for $20,000. Congratulations! But what does that look like when expressed in terms of ROI?
Thus, your ROI in this example is 100%. That’s quite a win! But this type of computation is usually a little more complicated. That cuts both ways.
In an ideal world, understanding one of the simplest financial measurements out there would be easy. But sometimes other factors influence these numbers, requiring us to modify our calculations.
Many companies, for instance, pay dividends to their shareholders. This example assumes that none were paid. But what if they were?
Let’s assume the same facts as above but also that the day before you sell your stock for $20,000 you were paid a $1,000 dividend. In that case, the math above would be replaced by this:
Thus, your ROI in this modified example is 110%. That’s not an insignificant performance bump!
The modified example highlights the risk in looking at purchase and sale prices alone for investment analysis. Other factors, like transaction or management fees, may bring your actual ROI down. That’s why clearly defining ROI and its significance is crucial. You could be missing some important perspectives when you only look at limited numbers.
Dividend stocks do not represent the only potential complicating factor in ROI calculations, and stocks are not the only investments that get evaluated on the basis of ROI. To this end, there are different types of ROI that typically get looked at alongside other performance metrics.
In real estate investing, for instance, ROI is just one of many numbers that help you evaluate your opportunities. Because those investment structures and strategies are often quite complex and reserved for accredited investors, the way money moves in and out can be complicated. You’ll want to look at other data points like IRR or MOIC to get a better feel for how well your money is working (this glossary is a great starting point for exploring those concepts).
Part of the reason these alternate measures become significant is that a straight ROI calculation does not account for the value of time. It’s one thing to make 30% on an investment over a period of two years. It’s another to make 30% over twenty. This is why statistics like IRR – which looks at the annualized rate of return on an investment – can prove useful.
Time matters in terms of risk management, as well. What would it mean for you and your financial goals to have a significant investment give you a 30% ROI, but your money would be locked up for 10 years to get it?
And ROI tells you nothing about what makes sense for you from a risk tolerance point of view. Two investments can offer the exact same raw ROI with wildly different volatility in their returns.
Imagine two relatively similar opportunities. Each might deliver 30% over five years. One might have gotten there by generating returns of roughly 6% annually. But the other might have only come out on top following a couple of years of steep losses made up for by a breakthrough year of winning. Do you have the stomach for the latter option, even if the ending is the same?
For this reason, savvy investors often look at metrics like the Sortino or Sharpe Ratios to compare their options. These will usually get layered on top of more qualitative due diligence when the investment is considered complex, like looking into a hedge fund manager’s history to evaluate consistency or setting your own rules for pro forma considerations.
And once all of that is said and done? You still need to consider how all of that information fits into a balanced, goal-aligned portfolio strategy.
At the end of the day, the goal of most investors is to make money. That means the bottom-line, all-in ROI on their investments will always play a driving role in their decision makings.
But chasing returns is pretty much always a terrible investment strategy. This is why understanding the function, limitations, and complexities behind ROI makes it more useful in the long run. Not because you shouldn’t want returns, but because you’re a lot more likely to realize them when making thoughtful, informed investment decisions.
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This is an updated version of an article from 2021. © 2023. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
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