Key Takeaways
- Return on investment (ROI) measures the gain or loss on an investment compared to how much you put in.
- A good ROI depends on factors like investment type, industry, risk, and time horizon.
- ROI should beat inflation, pay you for your risk, and beat or exceed any benchmarks.
- You can use an investment’s ROI to determine whether it’s a good investment and to make changes to your portfolio.
- The downsides of ROI are that it doesn’t factor in risk, time, and inflation.
Markets may perform well, but that doesn’t mean every investment is a good buy. There are different tools you can use to help you choose the right ones or swap out the ones in your portfolio that you feel aren’t performing up to your standards. One of the most common is the return on investment (ROI). This simple formula can help you cut through all the market news and noise and find the right investments for you, including those with the right growth potential.
How to Determine Return on Investment (ROI)
An investment’s ROI tells you how profitable an investment is, presenting it as a percentage. A higher ROI means the investment is profitable, while a negative one indicates a loss.
Basic ROI Formula
To calculate a stock’s ROI, subtract the cost of the investment (this includes any additional fees you may have paid at the time of the purchase, including brokerage fees or additional charges) from the current value of the investment. Then divide that result by the total cost of the investment. Here’s what the formula looks like:
ROI = (Current Value of Investment – Cost of Investment) ÷ Cost of Investment
Multiply that figure by 100 to get a percentage.
Let’s say you bought 10 shares of an investment at $250 each for a total of $2,500. Your total cost of investment was $2,500. The investment currently trades at $300 per share, which means your current investment value is $3,000. If you want to determine your ROI using the formula above:
ROI = ($3,000 – $2,500) ÷ $2,500
ROI = $500 ÷ $2,500
ROI = 0.2
When you multiply that by 100, your ROI would be 20.00%.
Note: If you paid any brokerage fees on the purchase, you would include that in the cost of your investment.
Calculating ROI for a Stock
Now that you know that basic ROI formula, you can use it to calculate the return for different investments. In this case, you subtract the purchase price from the sale price
ROI = ((Sale Price – Purchase Price) + Dividends) ÷ Purchase Price
Multiply that figure by 100 to get a percentage.
So, if you want to figure out your ROI for Company X, gather the information:
- Purchase price: $2,500
- Current price: $3,000
Let’s assume that the company pays you total dividends of $50 for all shares held. Using the formula above, let’s plug in the figures to determine your ROI:
ROI = (($3,000 – $2,500) + $50) ÷ $2,500
ROI = ($500 + $50) ÷ $2,500
ROI = $550 ÷ $2,500
ROI = 0.22
When you multiply that by 100, you end up with an ROI of 22.00%.
Adjust your sale and purchase prices for any fees and commissions. So, if your broker charges you $50 for your trades, you’d have to adjust your figures to $2,950 and $2,450, respectively, to get the correct ROI.
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Calculating ROI for a Bond
To calculate the ROI for a bond, subtract the amount you used to purchase the bond from the sale price. The sale price could be what you sell it for or its face value if you hold it until its maturity date. To that figure, add all the interest or coupon payments you receive while you hold the bond, and divide that result by the purchase price:
ROI = ((Sale Price – Purchase Price) + Interest or Coupon Payments) ÷ Purchase Price
Then multiply the result by 100.
Let’s say you buy a bond with a face value of $1,000, but you get it at the discounted price of $950. The bond pays you interest of $30 for the entire time you hold it. If you hold it until maturity, you can expect to receive the full face value of $1,000. Here’s what your ROI would be:
ROI = (($1,000 − $950) + 30) ÷ $950
ROI = ($50 + $30) ÷ $950
ROI = $80 ÷ $950
ROI = 0.084
If we multiply that figure by 100, we determine your ROI to be 8.42%.
What’s a Good ROI?
There isn’t a fixed number or overall ROI range for all investments. What makes a good ROI depends on a few factors, including the type of investment, the industry, the amount of risk you’re willing to take, your investment goals, and your investment time horizon.
If you have a longer time horizon, you’re probably willing to take on a greater degree of risk. That’s because you have more time to recover from market volatility, so it makes sense to add riskier investments with higher ROIs to your portfolio. You can also balance them out with low-risk investments as well to diversify your holdings.
The consensus is that any ROI should beat inflation and pay you for the risk that you’re taking. Riskier investments come with greater rewards, which means they have the potential for a higher ROI. Lower-risk assets like Treasuries focus on capital preservation, so they tend to have lower ROIs.
The ROI should either meet or beat the benchmark for that particular investment. So, if you’re looking at a tech company, make sure its return at least matches that of the Nasdaq Composite, which is one of the benchmarks for tech stocks.
The S&P 500 has returned an average annual return of about 10.55% since the index was introduced in 1957. Real returns drop to about 7% when adjusted for inflation, so a stock with an ROI above that percentage may be considered a good buy.
Warning
Past performance of an investment isn’t always a guarantee. Just because a stock has been returning above 10% over the last few years, that doesn’t mean it will continue to do so. Bad news can hit at any time, causing a company’s stock price to drop. So be careful of using historical data as your guide.
Benefits and Limitations of ROI
There are pros and cons of using ROI as a financial metric in your investment decisions. Let’s look at some of them
Benefits
ROI is an easy-to-understand metric that compares how much you gain or lose in an investment to how much you put into it. And it can give you a quick snapshot of whether a potential investment has made or lost money, giving you some insight into whether you may want to purchase it.
You can also use an investment’s ROI to determine whether it’s a good investment. It also allows you to make adjustments to your portfolio to align your holdings according to your investment strategy, investment goals, and risk tolerance.
Limitations
There are some things that ROI doesn’t account for, including:
- Risk: Although the ROI may be the same for two different investments, one may be riskier than the other. For instance, a blue-chip stock may have the same ROI as a startup, but the blue-chip is generally considered a safer investment than the startup because the chance of failure is significantly lower for the blue-chip stock.
- Time horizon: When you’re calculating an investment’s ROI, it doesn’t consider your holding period. An investment could return 5% in one year, while another may return 15% over 10 years. Although it seems like the second investment is a better bet, the first one has a better ROI when you factor in the holding period.
- Inflation: The formula for ROI doesn’t consider inflation, which can eat away at your returns over time.
The Bottom Line
ROI is a straightforward tool to help you compare the profitability of different investments. Adding it to your arsenal of tools may help you make better decisions that align with your long-term financial goals. Keep in mind, though, that it shouldn’t be the only tool you use. Make sure you use it with other key metrics to get a clearer picture of an investment’s performance and potential. If you’re ever in doubt, make sure you speak to a financial professional to help guide you in the right direction.