Return on investment (ROI) is what you get back in relation to the amount you invest. As your portfolio grows, you’ll want to monitor its performance to determine whether you’re on track to meet your goals.
As you evaluate your progress, you’ll need to be prepared to make changes — by selling some investments and buying others—if certain ones aren’t meeting your expectations.
As you monitor, though, you have to be realistic. If stocks in general are struggling to stay positive, as sometimes happens, you can’t expect the stocks or stock funds you own to provide a strong return. Selling them and substituting others isn’t likely to improve performance. And, in the long term, neither will selling everything and putting what’s left in a savings account.
By the same token, if the stock market is gaining value, you may want to consider replacing a stock whose return is still lagging. Similarly, you may want to replace a stock if the issuing company is in serious financial trouble from which it seems unlikely to emerge, and you want to avoid deeper losses.
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ROI formula and examples
The key to performance testing is return on investment (ROI), or what you get back in relation to the amount you invest, called your investment principal. If you start out with $1,000 and end up with $2,000, your return is $1,000 on that investment, or 100%. If a similar $1,000 investment grows to $1,500, your return is $500, or 50% — though of course, you could also have a negative return in any period.
ROI = Net Income / Cost of Investment
ROI = Investment Gain / Investment Base
But unless you hold different investments for the same time period, you can’t determine which has a stronger performance. What you need to compare your returns is the annual percent return, the average percentage that you’ve gained on each investment over a series of one-year periods. For example, if you buy a stock for $15 a share and sell it for $20, your profit is $5. If that happens within a year, your rate of return is an impressive 33% ($5÷$15=33.3%). If it takes five years, your average annual return will be closer to 7%, since the profit is spreadover a five-year period.
MEASURING TOTAL RETURN
In addition to any change in value measured by a gain or loss in market price, an investment’s total return includes any income it has provided, whether you reinvest the money or take it as cash. Examples are stock dividends, bond interest, and income distributions from mutual funds and other pooled investments.
Change in value +/– Income = Total return
You don’t actually have to sell, or realize your gain or loss, to calculate total return. You can figure it based on your unrealized gain. That’s also known as a paper profit or a paper loss.
Getting a good return on investments
There’s no absolute standard for determining a good return. The average return on different classes of investments — small company stocks, for example — over a specific historical period is a matter of record. And total return figures for mutual fund performance are reported regularly. You can compare how well your investments are doing against those numbers as a starting point.
Another factor to take into account when evaluating return is the current inflation rate. Your return needs to be higher than the inflation rate if your investments are going to increase in value. In fact, real return is reported return minus the inflation rate.
As a buy and hold investor, you select securities you plan to keep for an extended period because you expect long-term positive returns. If you trade investments, you make tactical buy and sell decisions, choosing investments when you expect them to gain value and selling when their growth matches your expectations or if the price stagnates or falls.
Both approaches may produce strong returns, though the second requires more constant attention and incurs larger trading costs. What doesn’t work is trying to time, or outsmart, the market with constant buying and selling.
Figuring return is not that simple
Figuring out the actual return on your investments can be difficult because:
- The amount of your investment changes. Most investment portfolios are active, with money moving in and out.
- The method of computing return can vary. For example, performance can be averaged or compounded, which changes the rate of return dramatically, as the chart below demonstrates.
- The time you hold specific investments varies. When you buy or sell can have a dramatic effect on overall return.
- The return on some investments—such as limited partnerships or some real estate investments—is difficult to pin down, partly because they’re not publicly traded.
You have to evaluate them by different standards than you do stocks or bonds, including the diversification they provide.
There are risks in bond investing. Issuers could default. If interest rates go up, you can lose money if you want to sell an older bond paying a lower rate of interest because potential buyers will typically want to pay less than you spent to buy it. Inflation is another risk. Since the amount you earn on a bond usually doesn’t change, its value can be eroded over time. For example, if you have a 30-year bond paying $50 annual interest, the income will buy less at the end of the term than at the beginning.
Compound vs average rate of return
Here are six sets of investment returns each totaling 27% over three years. While the average annualized return in each case is 9%, compound annual returns vary significantly. The most volatile investment, number 6, provided the weakest compound return despite having the highest one year return, at 40%, in part because it also had the two lowest, or –5% and –8%, and those losses occurred in the first two years, creating an initial deficit.
One of the things you’ll want to know as you evaluate performance is how well your investments are doing currently in comparison with other investments that have similar characteristics and return potential — large US corporations, for example, or telecommunications companies. That’s where benchmarks help. A benchmark is an index or average that reflects the changing value of a particular financial market or part of a market, called a sector. The benchmark serves as a standard against which to compare the performance of an investment that is part of that market or sector.
For example, the Standard & Poor’s 500 Index (S&P 500) tracks the performance of 500 large, widely held US companies. It’s the benchmark for large-company US stocks and the mutual funds and ETFs that invest in those stocks. Other benchmarks track small and mid-sized companies, long-term government bonds, types of mutual funds, and every other market segment you can think of, both in the United States and around the world.
Comparison with a benchmark provides relevant information, however, only when the investment belongs within the segment of the market that the benchmark tracks. You can usually find a list of relevant benchmarks by visiting the website of a company in which you’re interested.
Correct ROI Formula, Examples And Calculation Of Return On Investment by Inna Rosputnia
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