Aug 24, 2023
What Is Return on Investment (ROI)?
|What does return on investment mean?|
Return on investment (ROI) is a financial ratio used by investors to evaluate an investment’s profitability relative to its costs. Expressed as a percentage, ROI essentially tells you how much profit or loss you have on a particular investment.
ROI can be used to compare your investment’s performance to similar investments, rank the asset within your portfolio, and get a sense of how profitable your investments are. While it can be a useful tool in this regard, ROI is only one of many data points you should look at when calculating success. It doesn’t reflect factors like taxes, opportunity cost, or any brokerage fees you may pay.
In this article, we’ll discuss:
How to calculate ROI
You can calculate return on investment by dividing the net profit (how much you earned) by the cost of the investment, then multiplying that by 100 to get the percentage.
ROI = (net profit / cost of investment) x 100
The cost of the investment is how much you initially paid for it. You can calculate the net profit by subtracting the investment’s cost from its current value.
|ROI = ((current value of investment – cost of investment) / cost of investment ) x 100|
Example: calculating the ROI of a stock
Say you invested $1,000 in a single stock a few years ago and now decide to sell it. The stock has increased in value and is now worth $1,250. Here’s the calculation for your ROI:
ROI = (( $1,250 – $1,000 ) / $1,000 ) x 100
ROI = ($250 / $1,000) x 100
ROI = 0.25 x 100
ROI = 25%
It’s also possible to have a negative ROI if you sell an asset at a loss. Imagine you initially purchased a stock for $1,000, but it’s worth $950 when you decide to sell. In this case, your ROI calculation would be as follows:
ROI = (( $950 – $1,000 ) / $1,000 ) x 100
ROI = (-$50 / $1,000) x 100
ROI = -0.05 x 100
ROI = -5%
Example: calculating the ROI of a stock that pays dividends
When calculating your return on investment for a stock that pays dividends, it’s important to consider all the profits you’ve gained over a certain period, not just the change in the stock’s value. This includes any dividends you’ve received.
For example, say you bought $1,000 worth of a company’s shares and later sold them for $950. But you also earned $200 in dividends while you owned the stock. The ROI calculation would look like this:
ROI = ((($950 – $1,000) + $200) / $1,000 ) x 100
ROI = (-$50 + $200 / $1,000 ) x 100
ROI = ($150 / $1,000) x 100
ROI = 0.15 x 100
ROI = 15%
So, even though the value of your stock decreased, considering the dividends you received, your overall return on investment is 15%. This demonstrates how dividends can play a significant role in enhancing your investment’s overall profitability.
What is considered a “good” ROI?
What constitutes a “good” return on investment depends on many factors, including your personal risk tolerance, the time it takes for an investment to generate a return, and your goals. Risk-averse investors are more likely to accept lower returns in exchange for lower risk. On the other hand, those who are willing to take on more risk may chance a loss in their pursuit of higher ROI.
And remember that ROI isn’t a static figure; it will shift as the value of a stock changes over time. For instance, say you invest in a stock that’s experiencing very rapid but unstable growth. That investment might generate a very high ROI of 30% one year, but plunge to a much lower number the following year due to volatility in the share price.
What is the average stock market ROI?
The average stock market return is about 10% per year as measured by the S&P 500 index. Because of this average, many investors consider 10% a “good” ROI for stocks. But even this is an imperfect measure because the stock market can rise or fall, sometimes dramatically, in a given year. Therefore, many experts suggest that a realistic measure of “good” ROI is 5-7%.
If you’re looking at your investments’ ROI for a single year, it might be worth comparing your portfolio’s return that year against the S&P 500’s overall return in the same year instead of the 10-year average.
Stock market volatility is one reason that investing in a well-diversified portfolio over the long term is often recommended over a short-term investing strategy: it helps you ride out volatility so you won’t be as impacted by big drops in the market.
How to use return on investment
ROI is a relatively straightforward calculation that investors can use to judge the profitability of an investment. While it doesn’t tell the whole story, it allows you to evaluate performance at a glance. You might use a negative ROI to identify struggling investments and a positive ROI to see which assets are generally doing well. This information can come in handy when deciding whether to hold onto an investment or sell it.
Remember to look at the return on both your individual investments and your entire portfolio. When you diversify your portfolio, you’ll hold many types of investments. If some have a low or even negative ROI at the moment, those with positive ROI can balance out those losses. When diversified, your portfolio’s overall return is less likely to be heavily impacted by a single stock’s change in value.
ROI limits and benefits
Of course, ROI isn’t an all-encompassing data point. This statistic comes with some distinct benefits as well as some limitations.
|Benefits of ROI||Limitations of ROI|
|Relatively easy to calculate||Doesn’t take into account taxes, fees, or other investing costs|
|Provides a quick gauge of an investment’s profit or loss||Alone, doesn’t reflect the full picture of an investment’s performance|
|Can offer a means to evaluate portfolio performance||Doesn’t take into account your distance to retirement, goals, or risk tolerance|
When considering the performance of your investments, use ROI alongside other data points like:
- Time-weighted returns: Time-weighted returns are a measure used in finance to assess the performance of an investment portfolio, accounting for the impact of external cash flows. It helps you see how your investment choices perform without being swayed by when you put money in or take it out.
- Return on equity (ROE): Return on Equity is a financial ratio that evaluates a company’s profitability by comparing net income to shareholders’ equity. It tells us how good a company is at making money from the money its owners have put in.
Use these as well as all the costs associated with investing, such as management and trading fees charged by your brokerage.
Return on investment: the bottom line
Understanding your return on investment is one way to get a sense of your portfolio’s profitability. ROI can also be helpful when you start investing as a way to compare the return of two investments and evaluate the pros and cons of high-yield investments. It may also help you determine how much you should be investing to reach your goals based on your time horizon.
If you’re ready to begin your investing journey, Stash can help you find the right options for you unique risk tolerance, goals, and budget.
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