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Return on investment (ROI) is a metric used to understand the profitability of an investment. ROI compares how much you paid for an investment to how much you earned to evaluate its efficiency. Let’s take a look at how it’s used by both individual investors and businesses.
When you put money into an investment or a business endeavor, ROI helps you understand how much profit or loss your investment has earned.
Return on investment is a simple ratio that divides the net profit (or loss) from an investment by its cost. Because it is expressed as a percentage, you can compare the effectiveness or profitability of different investment choices.
ROI is closely related to measures like return on assets (ROA) and return on equity (ROE).
Return on investment (ROI) is one of the most important metrics investors use to evaluate potential investments But what exactly constitutes a “good” ROI can vary significantly depending on the type of investment and overall goals In this comprehensive guide, we’ll break down exactly what ROI is, how to calculate it, and provide guidelines for what makes a strong ROI across different asset classes.
What is ROI?
ROI measures the efficiency and profitability of an investment by comparing the cost to the return. Essentially, it helps answer the question – how much money am I making from my initial investment?
The calculation is simple
ROI = (Current Value – Cost of Investment) / Cost of Investment
For example if you invested $100 in stocks which are now worth $150. your ROI would be
($150 – $100) / $100 = 50%
The higher the ROI percentage, the better, because it means you’re earning more for every dollar invested.
Why ROI Matters
ROI is useful for several reasons:
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Performance benchmarking – ROI allows you to measure and compare returns across different investments in your portfolio.
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Assessing profitability – ROI helps you evaluate if an investment is generating enough income to justify the risk.
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Decision making – Comparing ROI can guide you in deciding where to allocate capital for the highest potential returns.
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Goal setting – Knowing typical ROI ranges for different assets can help you set realistic targets.
So by understanding ROI, you gain insight critical to managing your investments successfully.
How to Calculate ROI
Here are the key steps for calculating ROI:
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Identify your initial investment amount (principal or cost basis).
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Determine the current value of the investment.
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Subtract the initial investment from the current value.
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Divide the result by the initial investment.
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Multiply by 100 to convert to a percentage.
The basic formula again:
ROI = (Current Value – Initial Investment) / Initial Investment x 100
Some investments like stocks or real estate can get more complicated given factors like fees, taxes, and price fluctuations over time. But the same core math applies – compare how much you put in to how much you earned.
What is a Good ROI?
So what makes for a strong ROI? Here are general guidelines across asset classes:
Overall Investments
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Positive ROI – This means you’ve made money, which is generally good.
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5-7% – Historically, the stock market has delivered average annual returns of 5-7% after inflation. This is a common benchmark for overall portfolio ROI.
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10%+ – While positive returns are good, scoring an ROI consistently above 10% is considered exceptional.
Stocks
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7% – The average annual return for stocks after inflation. So this is a reasonable expectation.
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10%+ – For stock investments, an ROI exceeding 10% is quite strong.
Bonds
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4-6% – This range is generally considered a good ROI for bond investments.
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8%+ – While bonds are lower risk than stocks, achieving 8% or higher is seen as a very healthy return.
Real Estate
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10% – For rental real estate, an ROI of 10% is usually the baseline for a good investment.
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15%+ – ROI exceeding 15% is considered excellent for real estate.
Other Alternatives
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Cryptocurrency – Given the volatility, high double digit returns are often targeted.
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Peer-to-peer lending – Target returns are usually a stable 6-12% per year.
Factors Impacting Your ROI Expectations
When evaluating what makes a good ROI, you also need to consider:
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Time Horizon – Over longer periods, ROIs tend to be higher as early losses can be offset by later gains.
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Risk – Investments with higher risk need higher ROI to compensate for the increased chance of losses.
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Investment Goals – More aggressive growth goals warrant higher ROI targets than conservative objectives.
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Asset Class – Average returns and ROI expectations vary significantly across stocks, bonds, real estate, etc.
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Economic Environment – Periods of higher inflation or volatility make achieving strong ROIs more difficult.
So make sure to account for these factors when setting ROI targets and evaluating returns. A financial advisor can help customize expectations based on your full financial profile.
ROI Limitations
While ROI is useful, it has some key limitations to consider:
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ROI doesn’t account for time value of money. $100 earned over 5 years is not the same as $100 earned in 1 year due to compounding.
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Timing of cash flows is ignored – ROI treats all returns the same regardless of when they occurred.
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It doesn’t factor in risk – Investments with higher volatility may need higher ROIs to compensate.
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One-time snapshot – ROI captures returns only for a certain period, not the full investment lifecycle.
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No qualitative factors – ROI doesn’t measure things like investment growth potential, social impact, alignment with values, etc.
So ROI should not be the only metric used when making investment decisions. But as one piece of the puzzle, ROI remains a quick and useful calculation to assess financial performance.
How to Improve Your ROI
Here are some tips to improve ROIs on your investments:
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Review portfolio regularly and sell underperformers – eliminate assets dragging down overall ROI.
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Focus on long time horizons – extending holding periods allows more time for compounding.
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Reinvest profits – putting dividends/income back into investments grows the capital base earning returns.
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Minimize taxes and fees – reducing associated costs directly boosts the bottom line ROI.
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Ensure proper asset allocation – having the right mix of stocks vs bonds vs alternatives optimizes returns for a given risk level.
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Diversify intelligently – investing in non-correlated assets minimizes exposure to isolated losses.
Key Takeaways on ROI
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ROI measures returns on investments as a percentage by comparing current value to initial cost.
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It provides an easy metric to benchmark returns across different assets.
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Guidelines for a good ROI vary by investment type, but 10%+ is a strong return for most asset classes.
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ROI has limitations like ignoring time value of money and qualitative factors.
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Improving ROI involves maximizing compounding, minimizing costs, and optimizing asset allocation.
Understanding what constitutes a good ROI is key for setting realistic expectations and evaluating investments. While a single metric doesn’t provide the full picture, tracking ROI remains vital to smart portfolio management and achieving financial goals.
How to Use ROI
ROI may be used by regular investors to evaluate their portfolios, or it can be applied to assess almost any type of expenditure.
A business owner could use ROI to calculate the return on the cost of advertising, for instance. If spending $50,000 on advertising generated $750,000 in sales, the business owner would be getting a 1,400% ROI on the ad expenditure. Similarly, a real estate owner mulling new appliances might consider the ROI from two different renovation options, factoring in cost and potential rent increases, to make the right choice.
Just keep in mind that ROI is only as good as the numbers you feed into your calculation, and ROI cannot eliminate risk or uncertainty. When you use ROI to decide on future investments, you still need to factor in the risk that your projections of net profits can be too optimistic or even too pessimistic. And, as with all investments, historical performance is no guarantee of future success.
How to Calculate ROI
To calculate return on investment, divide the amount you earned from an investment—often called the net profit, or the cost of the investment minus its present value—by the cost of the investment and multiply that by 100. The result should be represented as a percentage. Here are two ways to represent this formula:
ROI = (Net Profit / Cost of Investment) x 100
ROI = (Present Value – Cost of Investment / Cost of Investment) x 100
Let’s say you invested $5,000 in the company XYZ last year, for example, and sold your shares for $5,500 this week. Here’s how you would calculate your ROI for this investment:
ROI = ($5,500 – $5,000 / $5,000) x 100
Your return on investment in company XYZ would be 10%. This simple example leaves out capital gains taxes or any fees involved in buying or selling the shares, but a more realistic calculation would factor those into the cost of the investment.
The percentage figure delivered by the calculation is ROI’s superpower. Instead of a specific dollar amount, you can take this percentage and compare it to the ROI percentage of other investments across different asset classes or currencies to determine which gives the highest yield.
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What’s a Good Return on Investment? (ROI Explained)
FAQ
What is a healthy ROI?
Is 30% ROI high?
Is 20% a good ROI?
Is 50% a good ROI?
