Return on Investment (ROI)

Return on Investment (ROI) is the percentage gain or loss earned on the money invested.  It is a very easy number to calculate using this generic formula:

ROI = equation.pdf X 100

This formula can be applied to any type of investment, including stocks, bonds, mutual funds, baseball cards and real estate, to name just a few.  To illustrate, consider the following example:

Assume you purchased a 1951 Bowman Willie Mays rookie card graded EX6 in mint condition in 2011 for $3,600.  Nine years later, you sell it to your brother-in-law for $7,800.  In this instance, the total amount you get is $7,800, and the total amount you paid is $3,600.  

Applying the formula:  ROI = equation_1.pdf x 100 = 116.67%.  This is your total return over the nine years.

The above is a very simple example that did not involve any commissions or other cash flows.  It is important to use the net amount you earned on your investment and the total amount you paid for it.  When you invest in stocks, bonds, or mutual funds, you generally have to pay your broker a commission both when you buy and when you sell.  Moreover, most of these types of investment pay interest or dividends, which is part of the return you earn.  For example, suppose you purchased 100 shares of Abbott Laboratories (ABT) at its close price on December 31, 2019 for $86.86 a share and sold it for $79.34 a share on March 31, 2020.  You paid a commission of $4.95 when you bought the stock and another $4.95 when you sold it.  The stock paid a dividend of $0.36 a share in January 2020.  

In this case, “what you get” from the investment is the price for which you sold the stock minus the commission that you paid to sell it plus the dividends you earned.  “What you paid” is the price at which you purchased it plus the commission you had to pay when you bought it.  

ROI = equation_2.pdf X 100

       = equation_3.pdf X 100 = equation_4.pdf X 100 = -8.35%

Note that your return on your 3-month investment in ABT is negative, primarily because you sold it for less than what you paid for it since the commissions paid were fairly negligible.  The dividends you received offset your loss from the sale somewhat, but not enough.

Businesses use the same formula to determine the return on an investment they have made.  For example, assume that a pizza shop purchases a new pizza oven for $5,800, which the owner determines contributed an additional $6,500 to the shop’s net profit in the first year. To determine the return on this investment, the same formula can be used:

ROI = equation_5.pdf X 100 = equation_6.pdf X 100 ≈12%

Time Value of Money

While this simple ROI equation is quick and easy to use, it has a number of drawbacks.  For one thing, it does not take the time value of money into consideration.  In our baseball card example, the holding period was nine years.  Bear in mind that $1 today doesn’t buy as much as it did 9 years ago, due to inflation.  If our selling price of $7,800 were adjusted for this, we would get a more accurate estimate of our real return over the 9-year period.

Sometimes people will erroneously rank investments based on their ROIs, which is also problematic.  For one thing, the two investments may have different levels of risk.  For example, a 1-year Treasury bill might provide an expected ROI of 1.5% while an investment in an S&P 500 Index mutual fund is expected to offer an ROI of 10%.  Does this mean that the mutual fund is the better investment?  Not necessarily.  Stocks are riskier investments than Treasury bills, which are considered risk-free.  The different risk levels need to be considered.

Another mistake that can be made when ranking investments based on their ROIs occurs when the investments are of different sizes.  If you were to invest $10 in an asset that will generate $20 in profits during the year, it would have an ROI of 100%:  ROI = equation_7.pdf X 100 = 100%.  A different asset that costs $100 will generate $125 in profits during the year for an ROI of only 25%: ROI = equation_8.pdf X 100 = 25%.  If you were to conclude that the $10 asset is the better deal, you would be wrong.  Notice that you will only be $10 richer if you invest in it (profit = $20 – $10 = $10), while you will be $25 richer if you invest in the more expensive asset (profit = $125 – $100).

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