How Does Return on Investment Work?

Return on investment (ROI) has become a mainstream term. It was originally used to define and compare the performance of securities investments. For example, the $1,000 profit you make on a stock investment may seem attractive until you figure its percentage return against other types of investments such as savings accounts. If you invested $100,000, your $1,000 profit would represent a return of 1 percent. Considering the risk inherent in stock market investing, you could have done better in a certificate of deposit at your bank, with much less risk.

Formula for ROI

To find the ROI of your investments, subtract the cost of the investment from the proceeds of its sale and divide that number by the cost of the investment. The result is the ROI expressed as a percentage. Include any fees or transaction costs in the investment cost so you get a clear picture of the actual return. If you lost money on the investment, your ROI will be a negative number, but it is useful to know the percentage loss so you can understand the full magnitude of the damage.

Significance

It is often difficult to see just how well an investment performed in relation to other opportunities, so figuring the ROI on your investment provides the brutal truth. It can be used prior to selling your investment in order to determine whether the performance warrants continuing to hold the investment. If the performance is not as good as provided by other investment options, the ROI will provide the signal to make changes.

Applications

ROI can be used to examine the wisdom of investment in houses, cars, employees, business trips, continuing education, and nearly everything else that can be quantified. For example, if you spend $20,000 on an advanced degree and it results in a $5,000 increase in your annual salary, your ROI will be 25 percent. You can now see that it will take you four years to recover your investment and begin to make a profit.

Considerations

ROI is a comparison tool best used in analysis of opportunities and relative performance, but it is not the only tool you should use in evaluating your investments. High-risk investments may produce a higher ROI than safer investments, but they have a greater downside risk, so in evaluating an investment, perform ROI analysis on a worst case scenario for both sides of your comparison in order to fully understand the potential of a risky investment compared to a safe one.

 

About the Author

I have 14 years of experience working with alcoholics and would like to write about this subject. I have included some of my articles on business and Internet marketing, but I am also capable of writing and editing other subjects.