How to Calculate Return on Investment

An investor cannot evaluate any investment, whether it’s a stock, bond, rental property, collectible or option, without first understanding how to calculate return on investment (ROI).This calculation serves as the base from which all informed investment decisions are made and, although the calculation remains constant, there are unique variables that different types of investment bring to the equation. In this article, we’ll cover the basics of ROI and some of the factors to consider when using it in your investment decisions.

On paper, ROI could not be simpler.To calculate it, you simply take the gain of an investment, subtract the cost of the investment, and divide the total by the cost of the investment. Or:

ROI = (Gains – Cost)/Cost

One major factor that doesn’t appear in an ROI calculation is time. Imagine investment A with an ROI of 1,000% and investment B with an ROI of 50%. Easy call – put your money in the 1,000% one. But, what if investment A takes 30 years to pay off and investment B pays off in a month? This is when time periods come into play.

Often it is easier to compare one investment to another by dividing the ROI by the number of years each one takes to mature. On a side note, to determine how long until your original investment will double, you divide 72 by the ROI.

The Bottom Line

ROI is a useful starting point for sizing up any investment. Remember that ROI is a historical measure, meaning it calculates all the past returns. An investment can do very well in the past and still falter in the future. For example, many stocks can yield ROIs of 200-500% during their growth stage and then fall down to the single digits as they mature. If you invested late based on the historical ROI, you will be disappointed. Projected or expected ROIs on an unproven (new) investment are even more uncertain with no data to back it up. For this reason, Investors must perform their due diligence and have a plan in place before making the investment. Otherwise, they are speculators.

Your Personal Wealth Ratio

In order to properly understand the purpose of a wealth ratio, we will first define wealth.

Definition of Wealth: The number of days you can survive without working.

What is a Wealth Ratio?

Your personal wealth ratio is the amount of passive income divided by your expenses.

Passive Income = Wealth RatioExpenses

If you have ever played Cashflow 101 or 202, you understand that when your wealth ratio is >1 you are technically out of the “rat race” and are financially free. This is because your passive income is greater than your living expenses allowing you to have an infinite number of days you could survive without working.

How to Increase Your Personal Wealth Ratio

There are two ways to raise your wealth ratio to 1 or greater. One is to raise your passive income, the other is to reduce your expenses. By choosing great passive income opportunities, you will be on your way to financial freedom. At the same time you can reduce your expenses. I recommend you take a look at your expenses each month and figure out what you need to make each month to live. Then set goals in order to move your personal wealth ratio to become greater than 1.

When your passive income is greater than your expenses, technically you be wealthy. This is how rich people switch to becoming wealthy people.

See you at the top!