Crash Course: The Rundown on ROI

The term ‘ROI’ is one you’ve most likely heard before, whether that’s in casual discussions or in financial circles. Despite its frequent use, many don’t truly understand how to correctly calculate or consider the ROI on a financial investment.

Return on Investment (ROI) refers to a measure of an investment’s profitability. It boils down to this question: what am I getting in return for what I gave?

In everyday conversation, ROI is often framed as the positive or negative consequence of our choices. For instance, the ROI for getting up early on a Saturday to tackle housework is the benefit of a clean home and a clear mind once you sit down to relax at night. A positive or negative ROI can help us assess whether the choice we made was worth the effort.

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. This is a simple enough calculation, but there are additional considerations that can complicate an investment’s ROI.

How To Calculate ROI

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. This is expressed mathematically as:

(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 sell it a year later for $20,000. Congratulations! So, what does that look like when expressed in terms of ROI?

• Step 1: Calculate the profit, which is the value of the investment minus its cost: $20,000 – $10,000 = $10,000
• Step 2: Divide the profit by the cost: $10,000 / $10,000 = 1
• Step 3: Multiply the result by 100: 1 * 100 = 100

Thus, your ROI in this example is 100%. That’s quite a win! However, this type of computation is usually a little more complicated. There are various factors that can either bump up or lower your ROI.

When ROI Calculations Require Additional Considerations

In an ideal world, understanding one of the simplest financial measurements out there would be easy. In practice, costs or payments beyond the purchase and sale prices can require 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:

• Step 1: Calculate the profit, which is the value of the investment minus its cost: $21,000 – $10,000 = $11,000
• Step 2: Divide the profit by the cost: $11,000 / $10,000 = 1.1
• Step 3: Multiply the result by 100: 1.1 * 100 = 110

Thus, your ROI in this modified example is 110%. That’s not an insignificant performance bump, and it highlights the risk in using purchase and sale prices alone for investment analysis.

On the other hand, factors like transaction or management fees, may also 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.

When ROI Is Not Enough

Dividend stocks do not represent the only potential complicating factor in ROI calculations. Stocks are also not the only investments that get evaluated on the basis of ROI. There are different types of ROI that are typically assessed alongside other performance metrics.

In real estate investing, for instance, ROI is just one of many numbers that help you evaluate your opportunities. Real estate investment structures and strategies are often quite complex and reserved for accredited investors. As such, 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 on real estate terminology is a great starting point for exploring those concepts.

These alternate measures are significant, partly because 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 years.

This is why metrics like IRR, which looks at the annualized rate of return on an investment, can prove more useful.

Returns, Risk, and Relativity

Time is also an important consideration in terms of risk management. What would it mean for you and your financial goals to have a significant investment that gives you a 30% ROI, but your money would be locked up for 10 years to get it?

Furthermore, ROI tells you nothing about what makes sense for you from a risk tolerance point of view. Two investments can offer the same raw ROI with wildly different volatility in their returns.

Imagine two relatively similar opportunities. Each delivers 30% over five years. One achieved this by generating returns of roughly 6% annually. In contrast, the other experienced a few years of steep losses and only came out on top following a breakthrough year that made up for the earlier losses. Even if the two investments led to the same ending, do you have the stomach for the latter option?

For this reason, savvy investors often look at metrics like the Sortino Ratio or Sharpe Ratio to compare their options. These calculations are usually layered on top of more qualitative due diligence when the investment is considered complex.This may involve looking into a hedge fund manager’s history to evaluate consistency or setting your own rules for pro forma considerations.

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.

ROI: Still the Most Relevant Number

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-making.

However, 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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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Digital Assets in Commerce & Bankruptcy
2. Real Estate Investing 101
3. Earning Green by Investing Green

This is an updated version of an article originally published on May 23, 2023. This article was most recently updated by the Financial Poise Editors.]

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