Return on investment (ROI) is a method to gauge how well an investment is performing. It can also be utilized to compare various investments.
There are several methods to calculate returns, and we’ll discuss a few of them in the upcoming chapter. For now, just know that ROI looks at the gains or losses in relation to the initial investment. In simpler terms, it gives you an idea of how profitable an investment is. A positive ROI indicates profits compared to the original investment, while a negative ROI signifies losses.
The ROI calculation isn’t limited to trading or investing; it applies to any business or purchase as well. If you’re thinking about starting or buying a restaurant, it’s wise to do some calculations beforehand. Would it be financially sensible to open it? Estimating an ROI based on your expected expenses and returns can guide you in making a more informed business choice. If it looks like the venture would yield a profit in the end (i.e., have a positive ROI), it might be worth pursuing.
Additionally, ROI can be useful for assessing the outcomes of past transactions. For instance, imagine you purchase an old exotic car for $200,000. After using it for two years and spending $50,000 on it, the car’s market value increases, and you can sell it for $300,000. Not only did you enjoy the car for two years, but it also provided you with a significant return on your investment. So, how much would that actually be? Let’s figure it out.
How to calculate Return on Investment?
The ROI formula is pretty straightforward. You start with the current value of your investment and subtract what you originally paid for it. After that, you divide that amount by the original investment cost. Here is the example:
ROI of BTC = (current value of BTC – original cost of BYC ) / original cost of BTC
The Limits
So, ROI is super straightforward and gives a universal gauge of profitability. But are there any downsides? Absolutely.
One major downside of ROI is that it overlooks the time factor. Why is this important? Because time plays a vital role in investments. There are other things to think about (like liquidity and security), but if an investment yields a 0.5 ROI in one year, that’s way better than a 0.5 ROI over five years. This is why some folks talk about annualized ROI, which shows the returns (gains) you might expect in a year.
However, ROI doesn’t consider other elements of an investment. A higher ROI doesn’t automatically mean it’s a better investment. What if you can’t find anyone to buy your investment and end up holding onto it for ages? What if the investment itself has poor liquidity?
Another thing to think about is risk. An investment might promise a really high ROI, but at what price? If there’s a significant chance it could drop to zero, or if your funds become locked away, then that potential ROI isn’t that significant. Why? Because the risk of holding onto this asset for a long time is pretty high. Sure, the potential gain could be substantial, but losing your entire initial investment is definitely not the goal.
Just focusing on ROI won’t provide insights into its safety, so it’s wise to look at other metrics too. You might want to start by figuring out the risk/reward ratio for each trade and investment. This way, you can get a clearer view of the quality of each bet. Plus, some stock market analysts might also take into account other factors when assessing potential investments. These could include cash flows, interest rates, capital gains tax, return on equity (ROE), and more.
Conclusion
We’ve looked at what return on investment (ROI) is and how traders can use it to make more informed investment decisions. The return on investment formula is a core part of tracking the performance of any portfolio, investment, or business.
As we’ve discussed, ROI isn’t the ultimate metric, but it can be useful. You also need to consider opportunity cost, risk/reward ratio, and other factors that may have an impact on your choice between different investment opportunities. As a starting point, however, ROI can be a good barometer to evaluate a potential investment.