How to measure your ROI?
Return on Investment, or simply known as ROI, is one of the best ways to calculate the performance of a given investment. Obviously, we can also use it to see its profitability and compare it to others. The higher ROI is, the better the investment. The worse ROI, the worse investment. If you want to know how to measure these elements, here is a quick tutorial.
It doesn’t matter what strategy you are using for trading - it can be day, swing, or index trading, or you can even apply long-term investments. Always think about measuring your performance to see if you are doing a good job. If you forget about that, you will never be able to maximize profits. Sadly, not everyone knows how to do that. However, trading gives you the opportunity to measure every single element and also, you have the opportunity to apply objective metrics.
What is it and how does it help us? As we all know, human beings tend to create their own narrative based on their experience, emotions, and other factors of everyday life. As a result, we may feel like something is a good decision even if others may treat this as something opposite. That is when objective metrics come into place. Numbers don’t lie. They present facts as they are. Even if we feel like we’re making a good investment, negative returns as well as long-term losses tell us otherwise. So, what to do in order to measure the performance of our investments appropriately?
First of all, let’s learn more about ROI itself
As it was already mentioned, the main goal of ROI is to measure the performance of your investments. What is more, it is quite often used to compare several different investments. It is used to see the gains or losses with the comparison to the initial funds we had for the given investment. To put it as simply as possible, this is an approximation that shows the profitability or the lack of it.
Interestingly, we can use it for different businesses - not only for trading or investing. It is also possible to calculate an estimated ROI for a brand new business you wish to open, like, for example, a restaurant. If the business has a huge probability of a positive ROI, then it is definitely something worth trying out.
ROI is also a great piece of equipment if you are to evaluate the results of already-happened transactions. If, for example, we were to buy an old apartment with great location for $400,000, restore it to premium quality finish with $100,000, and then sell it after several years for $600,000, then you will certainly gain quite a lot on that investment - let alone have a great place to live for a while. However, what are the exact numbers?
There is nothing difficult in finding out the ROI, because the formula is very straightforward. The only thing you have to know is the current value of the investment you did as well as the original investment. Then, you subtract the second from the first one, and divide the sum you receive by the original cost of the investment.
ROI = (current value - original cost) / original cost
Let’s take our apartment into consideration and see its ROI:
ROI = (600,000 - 400,000) / 400,000 = 0.5
Return on Investment for the apartment is 0.5. If you want to receive the rate of return (ROR, which is delivered in percentages), you have to multiply it by 100. In that way, you receive 50%.
This number did not take into account your expenditures and all the additional costs it was required for the apartment to be in such a great condition it currently is. So, we have to subtract that from the current value of the apartment, which gives us the current value of the apartment of $500,000
As a result, ROI with expenditures included is as follows:
ROI = (500,000 - 400,000) / 400,000 = 0.25
ROI as far as the apartment is concerned, is 0.25 (or 25%). If we were to multiply the cost of investment by ROI, we will receive net profit, which is $100,000:
400,000 x 0.25 = 100,000
There are; however, some limitations to ROI
Though it seems like a very interesting thing to use, we have to remember about several restrictions of ROI. For example, these approximations do not take time periods into account, which is quite an important factor for investment. For this reason, some people try to prepare annualized ROI, which is a bit more precise option, especially if our investment is expected to last longer than a year.
ROI can’t take some other elements of an investment under consideration. For example, not always higher ROI will be the indication of a better investment. Sometimes an option that is much more desirable on the market with worse ROI will be better than an asset that is difficult to get rid of.
One of the best examples is purchasing an apartment. Though it seems like a good investment (with ROI of 0.25), we have to remember that in order to get it into a desirable state, it can take more than a year - even two years. That is why the annualized ROI will be of much worse score than what we received. Another issue is that in order to sell an apartment, we have to wait for the right buyer and the time range can vary (depending on the market) from a month to even a year. That is why the ultimate annualized rate of return will be significantly lower than the ROI value presented at the top of the calculations.
If we were to look at other disadvantages of ROI, we should also take into account the risk
What is the point of investing in something with incredibly prospective ROI, if it is of grave danger? If there is a chance of an investment losing its value and, thus, making us lose all the funds, then great ROI is nothing of particular interest to us. If the potential reward is high, but at the same time there is a likely situation of losing all the funds, then you should think twice or even thrice before making a decision.
ROI is only a simple tool. Yes, it gives you insights into the potential profitability of the investment, but it won’t take into account the safety. You can always look at risk/reward ratio calculators, but this is a bit more demanding math.
Summary and conclusion
Now you know what ROI is, how to calculate it and in which situations we should use it. Also, we discussed the potential issues with ROI and its limitations. The examples provided at the top will certainly serve as a helping hand to all who just started their investing journey and wish to know more about the math behind it.
Return of Investment is surely one of the most important tools that every investor can use, especially if we take its user-friendliness into account. Obviously, it is not the ultimate equipment we should be following, because there are other options to consider like opportunity cost or even a calculation for evaluating risk/reward ratio. But it is still a good starting device to see if a potential investment is worth our time.