Return on Investment (ROI) Defined, Explained

Posted on Wednesday, August 29th, 2018 MarketBeat Staff

You may be familiar with the expression “You get out of it what you put into it.” This may be an accurate statement regarding a new workout plan, but it is exactly the opposite of what you want from your investments.

The primary objective of any investment should be to generate a profitable return – to get out of it more than you put in. Every investor wants to realize the greatest possible profit for the least amount of invested capital. Is this realistic? And how can you know how profitable your investments are? To know the answers to these questions you need an understanding of return on investment (ROI).

In this article, we’ll define what return on investment is as it relates to your portfolio. We’ll illustrate how you calculate ROI, discuss the different variables that can affect your return, and give you general guidelines for the type of return you can expect for a variety of investments.

What Is Return on Investment (ROI)?
Return on investment (ROI) is a performance measurement that shows your profit on an investment as a percentage of your overall investment. By comparing the ROI of one security to another you can make future decisions based on how efficient and effective your investment dollars are at generating profit.

How Do You Calculate Return on Investment (ROI)?

ROI is a straightforward calculation. All you need to know is the amount of money you have put into the investment and the current profit (or loss) on that investment. The calculation is:

ROI = (Current Value – Total Investment)/Total Investment

For example, let’s say you purchased 100 shares of Walmart stock in 2013 at a price of $73 per share. Five years later, that investment was worth approximately $96 a share. Assuming you did not buy any additional shares or sell any shares, your $7,300 investment would now be worth $9,600. Your ROI would be:

(9,600-7,300)/7,300 =31.5%. To get the average ROI per year, divide that number by the number of years (five). You’ll see that you have gotten a return on investment of just over 6 percent per year.

But how does that compare with other stocks in your portfolio?

At the same time, you purchased your Walmart shares, you purchased 100 shares of Coca-Cola stock at approximately $32.50 per share. After holding the shares for five years, they are now worth approximately $45 each. Your $3,250 investment is worth $4,500. Your ROI would be:

(4,500-3,250)/3,250 = 38%. That divides out to just over 7% a year.

You purchased the same number of shares. But in this case, your Coca-Cola investment was about half of your Walmart investment, but your return on investment was slightly higher with the Coca-Cola stock.

What Variables Affect Return on Investment?

This is an important factor to consider. As our examples show, we were working with the assumption that you made an initial investment and never purchased another share or took any profits. Either one of those situations (purchasing new shares or selling existing shares) would impact ROI. This is because ROI is only concerned with two things: the profit at a given moment and the money that you have put into it at that given moment.

This brings into play another variable: ROI itself does not take into account the amount of time that you hold a stock. What if I told you that I had a stock in my portfolio that had given me a 150% ROI? Would you be jealous? Not if I told you that that 200% ROI had come slowly over the last 45 years. That would be an average yearly ROI of just 3.3%. A positive ROI tells us that the value has gone up, but only when we know the timeframe can we get a sense of the rate at which the investment has grown.

Stocks can have different ROIs for different people, depending on the time the investor got in and out of the stock. For example, if you had bought and held the same Coca-Cola stock in our example above five years earlier and held it for ten years, your initial 100 share purchase would have only cost you $1,700 and you would be looking at an ROI of over 160% (an average of 16% per year). On the other hand, let's say you are told about an aggressive growth stock that has shown an ROI of 50% in just six months. Yes, please! Imagine you purchase some of the stock, the price keeps climbing, but then suddenly falls back to the same price at which you bought it. At that point in time, your ROI will be an unimpressive 0%.

Another variable to consider is that ROI is only meaningful if it's based on an actual return. Many penny stocks and other speculative investments (such as real estate) can state an expected ROI, but the only number that matters is the actual ROI you make in the end. Projected return is not the same thing as an actual return. Just because an investment is too new to have a track record does not mean it's a bad investment, but you can't and shouldn't compare its projected return to another investments actual return.

What kind of yearly return on investment should I expect?

Any investment has an element of risk and reward to it. How much your return on investment may be has a lot to do with the risk that you’re willing to take and a fundamental understanding of how different investments work.

This is important because when investors look at their portfolio, they don’t necessarily care about how much of a particular currency they own. That’s just a number. What they’re laser focused on is what that number can do for them (fund the lifestyle they want in retirement, pay for college, etc.). It’s the same as marketing 101. People are not investing for the feature (i.e. the numbers), they’re investing for what the numbers can do for them. 

With that said, one factor that will affect most investments is its rate of inflation. The rate of inflation essentially means how much the currency that an investment is purchased in has depreciated in value. Therefore, how much more of that currency is required to purchase the same items with that currency?  So let’s take a quick look at how inflation can impact ROI for different investments.

  • Gold – the precious metal is frequently discussed as being the ultimate inflation hedge. Advocates will frequently cite the 1970s when inflation was in the double digits and gold kept pace. Over the long-term, gold may still be that hedge, but in terms of ROI, there are few investments that show more volatility than gold, and therefore its hard to predict a reasonable ROI.
  • Cash – You've heard it said: "a dollar isn't worth what it used to be." That's not necessarily true; a dollar is still worth 100 cents (or 60 cents after taxes!). But what that dollar can buy you is quite different. The value of the dollar is much less. What this is saying is that cash will almost always have a negative ROI.
  • Bonds – If you're investing in good quality bonds, you can expect a return of 2-4% after inflation. Obviously, this is assuming normal circumstances and should be looked at as an average. An interesting point to be made here is that if investors purchase a riskier bond they will want a higher rate of return. The reality is that purchasing the bond with the potentially-higher ROI could wind up causing them to lose their entire investment (a -100% ROI).
  • Stocks – Looking back at our example above, Coca-Cola and Walmart are considered two stable, dividend-paying, salt-of-the-earth stocks. Their returns over five years … between 6-7 percent. When you factor in inflation, that’s about right. If a stock generates a 10% nominal return adjusted for inflation of about 3 percent, its real return is 7%.

How can investors misrepresent ROI?

Whenever someone quotes an ROI, you should know how they arrived at their calculation. As we said above, ROI is fairly straightforward if you’re assuming that a stock is purchased and the amount of money you put in is not adjusted in any way. Even if that does happen, investors need to account for any transaction fees both when they purchased it and again when they sell it.

A quick example can explain this:

If you purchased stock for $250 and later sold that same stock for $750, you might say that you got an ROI of 200%. But if you had to pay a $20 transaction fee when you bought the stock and another $20 transaction fee when you sold it,  the true ROI of this investment would be 184%.

Real estate investments are another example of investments where it can be easy to misstate ROI. This is because many investors think that the return on investment is created by subtracting the purchase price from the selling price and dividing by the purchase price. However, that calculation does not take into account the other costs that go into owning or renting the home. For rental properties, an investor might easily think about the things like how much the property has increased in value or the income they receive on the asset side, but not factor in their expenses like taxes, insurance, and all the maintenance costs they’ve put in over the years.

The Bottom Line on ROI

Investors should go into any investment plan with realistic expectations. While a 7% return on stocks is a reasonable ROI when you take out inflation, that percentage is only an average. Some years, you won’t get that high of a return and other years you may get slightly more. The point is, you have to have realistic expectations.

Markets don’t move in only one direction. One piece of news can send a stock into a tailspin right on the one-year anniversary of your purchase. If you calculate ROI on that date, you may be inclined to sell, but if you wait six months and the stock rebounds, you’ll be really glad you didn’t.

 


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