It's important to periodically evaluate your investments to determine how they’re performing. One often-cited yardstick for measuring investment success is known as return on investment, or ROI.
What is ROI?
Return on investment (ROI) is a metric that communicates how much profit or loss an investment delivered for you. It’s calculated by comparing your gain or loss against the initial cost of the investment.
The term is also often used by businesses to communicate the benefits realized by specific business ventures or product launches. It can also be used to estimate the potential return rate of a possible future project that may still be in the idea phase.
How does ROI work?
ROI essentially communicates the bang for your buck you’ve gotten for a given investment.
It’s a percentage figure that tells you what return you’ve earned for every dollar invested. For example, if an investment produced an ROI of 10%, it means that for every dollar you invested, you earned 10 cents.
How to calculate ROI
There may be nuances to calculating ROI, depending on the investment type. But generally, you can calculate ROI with a straightforward formula:
(Investment’s total proceeds – investment’s total cost) / Investment’s total cost
To provide the most comprehensive look at an investment’s ROI, you should typically include any payments you’ve received along the way—like dividends or interest—when you tally up “total proceeds.”
You should also always be sure to account for the impact of any fees or expenses associated with the investment. For example, if you paid purchase fees or commissions up front when you bought the investment, include these in your calculation of the “total cost.” Many investments, such as mutual funds and ETFs, report performance figures net of the cost of annual expense ratios, so you may not need to deduct for these. But double-check what fees you have paid or are paying for an investment, and be sure these are accounted for in your calculation.
Learn more about the ROI formula and how to calculate ROI for various specific types of investments.
Why is ROI important?
It’s important to understand how your investments have performed so that you can assess whether they’re all pulling their weight as expected in your portfolio.
There’s more than one way to slice the numbers in assessing an investment’s performance. ROI can be useful because it’s a simple calculation that provides a comprehensive look at an investment’s cumulative total return.
Disadvantages of ROI
While ROI can give you a simple high-level view of an investment’s returns, it’s a fairly blunt tool, and does come with some drawbacks. Those include:
1. It doesn’t account for time frame
The simple ROI formula is good at telling you how you much earned on every dollar invested. But it doesn’t take time—how long you held the investment—into consideration. For example, suppose investment A returned 15% over 1 year, but investment B earned 20% over 2 years. Based on ROI alone, investment B would look stronger. But investment A might actually be the higher-returning investment.
2. It doesn’t account for risk
In investing, risk and return usually go together. If you want the potential for very high returns, you typically must take on high risk—and if you want low risk, you typically must accept lower returns. ROI might make a higher-risk, higher-returning investment appear “better” than a lower-risk investment. But in reality, there are often tradeoffs between higher-returns-potential and lower-returns-potential investments to understand. Different investments can also come with different types of risk—not just different degrees of risk.
3. It can be incomplete
In addition to time frame and overall risk, there are other ways in which ROI can gloss over important nuances. For example, some types of investment returns face higher or lower tax rates than others, meaning after-tax ROI could look very different from before-tax ROI. It doesn’t consider how a given return rate looks relative to peers—for example, a mutual fund that delivered 5% over a given time frame might appear low-returning at first glance, but might actually be an outperformer if similar funds lost money over the same time frame. And it doesn’t consider an investment’s correlation with other investments—i.e., whether it tends to go up or down in tandem with other investments.
Those are some of the reasons why ROI generally shouldn’t be the only figure you rely on when evaluating investments.
What is a good ROI?
A good return on investment depends on the time horizon, investment type, overall financial environment, and risk, among other factors. Consider comparing an investment’s return against returns of similar investments over the same time period. For example, if you want to know whether a tech stock has delivered a strong ROI over the past 3 years, you could compare it against an index of tech stocks over the same 3-year period.
However, recall that a higher ROI is often associated with more risk. And always keep in mind that past performance is no guarantee of future results, so an investment’s past ROI might not be indicative of its future ROI.
Alternatives to ROI
As mentioned above, a simple ROI calculation glosses over a lot of important nuances. Here are some other measures you can use to build out a more complete picture of an investment’s performance:
Annualized total return. This metric converts an investment’s performance into an annual rate of return, and so adjusts for differences in time frame.
After-tax total return. As the name suggests, after-tax returns look at an investor’s take-home gains after paying taxes on their investments, and so helps account for the differing tax treatments of various investments and accounts. (Note that if investors are in different tax brackets they could face different after-tax returns, even if they hold identical portfolios.)
Risk-adjusted return. In general, higher-returning investments often come with more risk. Calculating risk-adjusted returns can help investors understand whether an investment has been providing returns commensurate with its level of risk.
How to use ROI with your investments
Being able to calculate ROI for your investments is useful for a simple reason: It tells you, immediately, whether an investment has been profitable or unprofitable and how profitable (or unprofitable) the investment has been. And it does this with a relatively simple calculation.
For a more complete understanding of your portfolio performance, you’ll likely need to rely on other metrics. But ROI is a solid way to get a quick high-level view with simple calculations.
Learn more about how to give your portfolio a checkup and about common reasons for portfolio underperformance. If you need help in crafting a portfolio that suits your needs and goals, learn more about how we can work together.