In this article, we'll cover the basics of ROI and some of the factors to consider when using it in your investment decisions.
On paper, ROI could not be simpler.
To calculate it, you simply take the gain of an investment, subtract the cost of the investment, and divide the total by the cost of the investment.
Or:
ROI = (Gains – Cost)/Cost
For example, if you buy 20 shares of Mikes store for $10 a share, your investment cost is $200.
If you sell those shares for $250, then your ROI is ($250-200)/$200 for a total of 0.25 or 25%.
This can be confirmed by taking the cost of $200 and multiplying by 1.25, yielding $250.
There are a couple different ways to think about this.
The popular one is to picture each dollar invested in this stock paying 25 cents to you. Putting more money in the stock will result in a larger total payout, but it won't increase the ROI.
The ROI will be 25% whether $200 grows to $250, $2 grows to $2.50, or $200,000 grows to $250,000.
Because it is a percentage, ROI can clear up some of the confusion caused by just looking at dollar value returns.
Imagine two of your friends, Diane and Sean are telling you about their investments.
Diane made $100 investing in options and Sean made $5,000 investing in real estate.
Both these numbers will be their return – their profits after costs have been subtracted.
With only that information, most people would assume that Sean's investment is the better one.
However, without understanding the costs of the investment, we can't make any accurate conclusions about the return.
What if Sean's costs were $400,000 and Diane's were only $50?
This would mean Sean's ROI is 1.25% while Diane's is 200%, a clear win for Diane.
The dollar value of the return is meaningless without considering the cost of the investment.
For this reason, the costs of an investment, both initial and ongoing, are an essential piece of information for any investor.