ROI stands for Return on Investment. As the name clearly suggests, it is the amount or percentage of returns you achieve on investments you make. Your ROI depends on numerous factors, and it also helps you decide many factors too!
We will be talking all about return on investments in this article. But before that, let’s get a clear idea about what ROI is in-depth.
Table of Contents :-
What is ROI (Return on Investment)?
As I have mentioned above, ROI or return on investment is the profit you gain from your investments and assets. It also acts as a measurement tool to see if your investments performed well. You can also calculate the efficiency of your investment or the number of investments based on this figure of ROI.
You can calculate the amount of ROI by subtracting the current value of your asset and the Invested amount.
Return on Investment = Principal Invested Amount – Current Value
ROI % = (Current Value – Cost of Investment)/(Cost of Investment) * 100
Here, the Current Value refers to the asset’s current price or the price you’ll get if you sell it. I showed you the percentage and valued formula for ROI. However, in general, ROI is referred to in percentage.
One thing to note is – Your ROI can be positive as well as negative. That is, suppose you bought a stock for $100, and after one year, its value drops to $90. In this case, your ROI or return on investment becomes negative. It’s -10%.
Similarly, if its value rises to $110, your ROI becomes +10%.
Say you bought Google stocks for $1000, and a year later, you sold the stocks for $1500. Here you booked a profit of $500, and your ROI is 50%.
ROI% = [ ($1500 – $1000) / $1000] * 100 = 50%
Simple and Effective Metric
As we can see above clearly, the ROI is the most popular metric in the world of investment. It is easy to understand, simple to calculate, and efficiently describes your investments. It acts as the Gauge of your profits in your investments.
Calculation of ROI is simple multiplication-division. It helps you look upon your decisions, alter them, and invest better. Also, it’s not only for Personal Finance. ROI is used majorly in industrial and organisational decisions. The ROI of a company or organisation helps it decide the future course of the company.
For example – Say Google invested in YouTube. After a course of 5 years, its ROI surpasses anything. Now that ROI is massively positive, Google will definitely take better and more thoughtful decisions about YouTube. Do you get the idea now?
Let’s take a personal finance example for you to relate. Suppose you bought a stock of Google and a stock of Facebook. After one year, the price of Google’s stock rises, and that of Facebook goes down. N this will trigger you to make decisions. It doesn’t matter what decision you take; the point is – you decided after looking at the ROI.
ROI has limitations too
The biggest limitation of ROI is that it doesn’t consider the time and period for which one remains invested. Let me tell you this point with an example –
You bought two assets –
- Stocks of a company ‘5 years ago. Its current value is Double the cost price.
- Real estate property that was bought ’10 years ago. Its current value is Thrice the cost price.
Here we see that the ROI on real estate is 300%, while the ROI of stock is 200%. From this figure, we see that you have booked more profit on the real estate. But we don’t see the fact that you had to wait for ten years to get that 300% ROI. Who knows, the stocks after 10 years would have given a 400% ROI!
Let us annualize the investments –
- For the real estate – You booked 300% ROI in a 10-year period. If you divide the 300% ROI by 10, you get 30% of yearly numbers.
- Similarly, for the stocks – Divide the 200% ROI by 5. You get an annual number of 40%.
Did you see the difference? If we see yearly figure, stocks have given 10% better result than real estate.
You get the idea now? It doesn’t take into account the time, which is one of the most important aspects of Investment and Compounding.
Overcoming the Limitation
In the previous section, we saw the shortcoming of ROI. It doesn’t take into account the time frame. Now, the solution to this limitation is RoR.
RoR stands for Rate of Return. RoR of an investment takes into consideration the time frame of your investment. One can also use NPV to consider time and adjust the returns for Inflation too.
NPV stands for Net Present Value. It tells you the difference in your money value over a period of time. It is also an important tool in the finance world because Inflation is the real deal. I will be talking about inflation separately in another article.
But for now, let’s keep it to NPV and RoR.
RoR, when accounted with the NPV – gives the real rate of return, also abbreviated as RRoR. This RRoR helps you adjust and reflect your understanding along with your investment performance that covers a multi-year period. It doesn’t matter how many years we are talking about, it perfectly reflects the time-period analysis.
Evolutions in ROI
As we know that ROI takes into account our financial metrics. In the late 1990s, certain personalities thought about the social and environmental aspects of increasing industrial and financial sectors. They wondered what could be the social impact of such changes.
That is when a new term coined, called the SROI. The Social Return on Investment. It considers the broader and thoughtful impacts of financial changes on the society and environment. However, it did not become as popular and widely used as the ROI.
ESG, SRI and ROI
The ESG criteria incorporated in SRI (Socially Responsible Investing) is monitored under the SROI. ESG stands for Environmental Social and Governance. For example, suppose you have a factory that uses a lot of water and lighting. Say you decided to set up a water recycle plat so that you can reuse the waste water. You also invest in solar panels to run your factory electricals.
This decision may initially decrease your ROI. But the rise in SROI will tell you that your decisions benefit the Society and Environment. Now one might think what the need to take such decisions that lower our ROI is. But being in a position to take such actions, it is our moral duty to act. We ought to give back to society as much as we can.
Good ROI, Bad ROI
Now, what metric can be defined as a Good ROI or the Bad ROI? This, too, depends on your Risk Appetite. Say, if you have an appetite for high risk, your definition of good ROI maybe 20-25% against the normal 15%.
and bad ROI for the sane profile would be 8-14%. So, it can’t be generalised. It totally depends on an individual, their risk tolerance and investment period too.
Was it concise and clear? In case you had too much of technical information to consume and it overwhelmed you, I’ll tell you one thing. Wherever you invest or save or anything, look for ROI to be above 9%. That’s it. You do not have to dive in the technical or mathematical aspects if you don’t want to.
Everything has been laid out for you in this article in detail. But I want to make your basics strong. So I do not mind if you ignore most of the article, unless you clearly understand what ROI is and how you calculate it. Rest can be pretty much fine.
Do you still feel confused? Don’t worry; we got you! Comment Below, And we will reply to you within 24 hours or Just Hit us with a DM on Instagram @capitalistcabin. We would love to help you. Till then – We would love you to read our Personal Finance blogs!
Do tell us in the comments which stock you want to buy first? Happy Investing :)!