ROI is short for “return on investment”. It’s a term often used by business owners. But what does ROI meanto individual investors and is it important? If we break this down a little you’ll easily understand the meaning of “return on investment” and why it’s so important to anyone who wants to make smart investments.
ROI is a calculation that you can (and should) make to compare different investment opportunities. To do the calculation, you simply take the expected net return you hope to earn and divide it by the investment you are required to make. If your head is spinning. Don’t worry. Let’s take an example and break this down.
Lets say your cousin asks you to loan her $10,000 for a month. In exchange, she’s willing to pay you simple interest of $200. If your cousin is good at paying back her debts, you should jump on this opportunity. Why? Because the ROI is an astronomically high 24%. How did we calculate this number?
You earn $200 in one month in exchange for loaning your cousin $10,000. The way to calculate ROI is to take $200 and divide it by $10,000. That works out to a 2% return in that one month. But 2% per month is 24% per year. This is also your time weighted return. In this case, your return is 24%. Sweet Molina! When you calculate the ROI, you can easily determine if you have a profitable investment or not.
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Lets take a look at another example. Let’s say you own rental real estate free and clear worth $500,000. Assume you rent it out and after all your expenses (repairs, insurance and taxes) you pocket $20,000 a year. Your ROI is 4% a year. Easy.
Now, these illustrations demonstrate a few very important points about what ROI really means for investors.
First, at the end of the day, ROI is a function of money in versus money out. If you are comparing different mutual funds for example, this is highly useful. Let’s say one Fund X had a 12% ROI last yeasr and Fund Y had a 15% ROI. Fund Y is a better investment. Right? Yes.
Does it matter what the fund expenses were for Fund Y? Not at all. Remember, ROI considers your net returns. And when it comes to mutual funds, your net returns are calculated after all fund expenses are considered. There are people who only buy funds with the lowest expenses like ETFs. I think this can be helpful sometimes. But it is far more important to consider net returns in deciding which fund to buy rather than base your decision on costs.
If costs are important that manifests itself in lower returns and a lower ROI. And if the fund has a lower ROI you won’t buy it. You don’t have to worry about fund expenses when you make your investments based on ROI. It all comes out in the wash. Scrub-a-dub-dub.
The second topic that comes to light when you look at ROI is the “r” or return. You can always determine historical returns but that may not mean a thing about what the future has in store. In fact, they say that the past is no guarantee of future returns for a reason – because it’s true.
For stock, ETF and mutual fund investors, ROI is impossible to predict and only relevant with respect to historical performance. If you use an investment strategy that picks funds based on historical performance, ROI is important. If you are trying to predict future returns (something I suggest you avoid), ROI is problematic.
ROI (return on investment) is a really handy tool for investors. It helps you compare apples to apples when you consider alternative investments. In order to use ROI effectively all you need to know is how much money you are going to invest and how much money you are going to get out of the investment.
If you have this information, you’ll be able to make a smart decision. Without it, you’ll have to decide based on your predictions for the future.
Do you calculate ROI on your investment alternatives before making any decision? Why or why not?
Neal Frankle is a Certified Financial Planner with more than 25 years of experience, author of the Wealth Pilgrim blog, and a featured contributor here on the “CIF Blog”!