Definition, equation, how to calculate it


  • Return on Investment (ROI) is a measure used to assess the performance of a particular investment.
  • Return on investment is expressed as a percentage and can be calculated using a simple return on investment or annualized return on investment equation.
  • Examining ROI does not take into account risk tolerance or time and may not show all costs.
  • Visit Insider’s Investment Reference Library for more stories.

Return on Investment (ROI) is a financial ratio used to measure the profitability of an investment relative to its costs and is expressed as a percentage. When you are considering investing in anything you often hear about a ‘return on investment’ but you might be wondering what it really means and how it works. Here’s what to consider with ROI.

Why return on investment matters

When you invest, whether in the stock market or in your business, your goal is to make money and get a return on your investment. You invest money with the expectation that what you invest will provide an even greater return on your investment.

“Return on investment is expressed as a percentage and is calculated by subtracting the cost of an investment from its current value and then dividing it by the cost,” explains Nicole Tanenbaum, partner and chief investment strategist at Checkers Financial Management at San Francisco. “It’s a simple, straightforward formula that can be easily used to calculate the approximate profitability of almost any investment, from equity investments to business projects to real estate transactions.”

As an investor, it’s important to assess ROI as a financial metric to see how your particular investments are doing. Basically, are you getting more than what you invest? Or are your investments costing you, in the form of negative returns?

Return on investment goes hand in hand with risk and reward, which means that with greater risk comes the potential for even higher rewards.

According to Investor.gov, a website operated by the Securities and Exchange Commission (SEC), for many decades, stocks have had the highest average rate of return, but also tend to carry the highest risk.

Return on investment is important because it is an easy-to-use measure for evaluating the performance of an investment. Expressed as a percentage, the higher the number, the higher the yield.

If an investment doesn’t have a solid ROI, it might be a good time to rebalance your portfolio and sell some assets that aren’t performing well. However, it’s important to consider the transaction costs and the effects on your overall long-term returns.

How to calculate return on investment

To calculate the ROI, you can use the following formula:

Return on investment formula


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Let’s break down the pieces of the ROI formula.

  • Net investment gain refers to the net return you get on an investment, after taking into account costs already incurred.
  • The cost of the investment is the total amount of money you have invested in a particular investment.

To calculate ROI, you take the net investment gain and divide it by the cost of the investment and multiply it by 100 (this converts it to a percentage).

For example, suppose you make an initial investment of $ 10,000 in shares of a company. Then you decide to sell your shares three years later for $ 12,000.

Here is the simple ROI formula in this case:

return on investment = ($ 12,000 – $ 10,000) / $ 10,000

In other words, you take the final sale of $ 12,000 and subtract the original investment of $ 10,000, which gives you a net investment gain of $ 2,000.

You then take that number and divide by the cost of the investment.

return on investment = $ 2,000 / $ 10,000 = 0.2

The last part of the equation is to multiply the decimal number by 100 to get the percentage.

0.2 X 100 = 20%.

This simple ROI formula is pretty standard when evaluating returns. But the downside is that it doesn’t take into account how long you’ve held the investments or any opportunity costs.

Annualized ROI can offer more nuance when it comes to how long an investment is held and provide a more accurate ROI. Here is the annualized ROI formula for our example:

Annualized return on investment formula


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A = ($ 12,000 / $ 10,000) (â…“) -1

A = (1.2) (â…“) -1

A = 1.063-1

A= 0.063

A= 6.3%

As you can see, Simple ROI and Annualized ROI are quite different. Looking at the annualized return on investment can provide better insight into how an investment is performing if you hold it for a significant portion of the time.

It is also important to note the difference between a realized gain and an unrealized gain.

  • A realized gain is the total you earn or profit from an investment that you actually sell. In this case, you would want to use the net income as part of the net investment gain and include all transaction costs, fees, etc.
  • An unrealized gain is a gain “on paper”. In other words, it reflects an increase in value but since it is not actually sold it is not realized. In this scenario, you would take the value of your current investment to calculate the net investment gain.

Advantages and disadvantages of ROI

While measuring ROI is a good way to measure performance, there are some limitations, especially when it comes to the simple ROI formula. Here are the pros and cons of ROI:

You want to weigh the pros and cons and know where the ROI metric may be failing.

“Return on investment can be a useful tool for comparing the performance of multiple investments. However, it is important to understand that ROI does not take into account the overall timeframe of an investment, nor the time it took to generate the overall profit from the initial purchase to eventual sale, ”says Tanenbaum. .

Time is a key factor when evaluating the true return on investment of a particular investment.

“Time is a factor that should always be taken into account when evaluating and comparing the relative performance of different investments,” says Tanenbaum. “Even if an investment generates a higher profit based on its return on investment, the longer the lead time, the less efficient the investment. Therefore, ROI should be used in tandem with other performance metrics such as rate of return, which takes time and efficiency into consideration. ”

Average ROI on the stock market

The reason why it is better to invest than to keep money in a savings account is that the possibility of a higher return is much greater. Interest rates on savings have been extremely low, but the stock market has historically offered good returns over time.

According to the SEC, the stock market has provided annual returns of around 10%, or 6% to 7% taking into account the impact of inflation.

Some returns are much larger depending on the type of investment and the time period.

“On average, the S&P 500 stock index has generated a return on investment of around 10% per year over time, but when you look at the return on investment from one sector to another, it can vary. significantly, with higher growth segments generating an average ROI well above 10%, and more defensive industries generating single-digit or, in some cases, negative ROI, ”Tanenbaum notes.

In addition to evaluating the return on investment, don’t forget to also take into account “realized” versus “unrealized” gains. This is also important for losses. So if the stock market collapses, you don’t necessarily need to take action because the loss is “unrealized” until you sell. If you sell at a loss, it’s final. But if you stay in the game, you might recover in the long run.

The financial report

Return on investment is a commonly used metric to evaluate investments and business decisions. Ideally, your return on investment will be positive and will increase over time, but it is also possible to get negative returns.

Return on investment can help you decide where to invest and whether to sell or hold the assets you already own. While the ROI percentage is useful, it is important to understand its limitations when evaluating overall risk and time horizon.

Additionally, it’s important to understand the nuances between simple ROI and annualized ROI. You also want to be clear about the total costs such as transaction fees, taxes, etc., so that you have a clearer picture of your actual return on investment.

About Geraldine Higgins

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