Return on investment

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Return on investment (ROI) is a metric used to lớn understand the profitability of an investment. ROI compares how much you paid for an investment lớn how much you earned to evaluate its efficiency. Let’s take a look at how it’s used by both individual investors và businesses.

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What Is ROI?

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. It is closely related khổng lồ measures like return on assets (ROA) và return on equity (ROE).

How khổng lồ 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 & multiply that by 100. The result should be represented as a percentage. Here are two ways to lớn 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 & compare it khổng lồ the ROI percentage of other investments across different asmix classes or currencies to lớn determine which gives the highest yield.

How to Use ROI

ROI may be used by regular investors khổng lồ evaluate their portfolquả táo, or it can be applied to assess almost any type of expenditure.

A business owner could use ROI khổng lồ 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 và potential rent increases, khổng lồ make the right choice.

Just keep in mind that ROI is only as good as the numbers you feed into your calculation, và ROI cannot eliminate risk or uncertainty. When you use ROI lớn 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.

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What Is a Good ROI?

According khổng lồ conventional wisdom, an annual ROI of approximately 7% or greater is considered a good ROI for an investment in stocks. This is also about the average annual return of the S&P.. 500, accounting for inflation. Because this is an average, some years your return may be higher; some years they may be lower. But overall, performance will smooth out lớn around this amount.

That said, determining the appropriate ROI for your investment strategy requires careful consideration rather than a simple benchmark. The S&P 500 may not be appropriate for the cấp độ of risk you’re willing khổng lồ take on or the asmix class you’re investing in, for instance. To calculate the ROI that’s good for you, ask yourself the following questions:

How much risk can I afford khổng lồ take on?What will happen if I thua the money I invest?How much profit vày I need for this investment to take on the prospect of losing money?What else could I vị with this money if I don’t make this investment?

Limitations of ROI

ROI is not without limitations. First & foremost, ROI does not take time into lớn trương mục. If one investment had an ROI of 20% over five years và another had an ROI of 15% over two years, the basic ROI calculation cannot help you determine which investment was best. That’s because it doesn’t take inlớn account compounding returns over time.

Annualized ROI can help avoid this limitation. To calculate annualized ROI, you need lớn employ a little bit of algebra. The value n in the superscript below is key, as it represents the number of years the investment is held.

Annualized ROI = <1 + (Net Profit / Cost of Investment)> (1/n) – 1 x 100

If you bought a portfolio of securities worth $35,000, và five sầu years later your portfolio was worth $41,000, you’d have sầu earned an annualized ROI of 3.22%. The formula would look like this:

Annualized ROI = <1 + (6,000 / 35,000)> (1/5) – 1 x 100 = 3.22%

Accurate ROI calculations depkết thúc on factoring in all costs, not merely the initial cost of the investment itself. Transaction costs, taxes, maintenance costs and other ancillary expenditures need to lớn be baked inlớn your calculations.

Finally, an ROI calculation that depends on estimated future values but does not include any kind of assessment for risk can be a problem for investors. It is easy to be tempted by high potential ROIs. But the calculation itself does not give any indication of how likely that kind of return will be. This means investors should tread carefully.

The Bottom Line

ROI is an understandable & easily calculated metric for determining the efficiency of an investment. This widely used calculation allows you lớn compare apple-to-apples among investment options.

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But ROI cannot be the only metric investors use to make their decisions as it does not account for risk or time horizon, và it requires an exact measure of all costs. Using ROI can be a good place to start in evaluating an investment, but don’t stop there.

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