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.