Summary

Return on investment (ROI) can be used to measure investment performance and is also a good way to compare returns from different investments. Investments with a high return on investment (ROI) are clearly better than investments with a low (or negative) return on investment (ROI). Wondering how to use it to measure your personal portfolio? Please read this article to find out.

Introduction

Whether you are day trading, swing trading or long-term investors, you should measure your own Investment performance. Otherwise, how do you know whether your investment is successful? One of the great things about trading is that performance can be rigorously measured using objective metrics. This also goes a long way toward eliminating emotional and cognitive biases.

So, what's the use? When the human brain tries to understand the world, it always interprets everything around it logically and consistently. However, in the face of numbers, everything is lost. If the returns are negative, you should find a way to change your strategy. Likewise, if an investor thinks their investment is doing well but the numbers suggest otherwise, bias may be to blame.

We discussed risk management, position sizing, and placing stop-loss orders. But how do you measure investment performance? And how do you compare the performance of multiple investments? This is where return on investment (ROI) calculations come in. In this article, we will discuss how to calculate return on investment (ROI).

What is return on investment (ROI)?

Return on investment (ROI) is a way of measuring investment returns and can also be used to compare different investments.

There are many ways to calculate returns, some of which we will cover in the next chapter. For now, all you need to know is how to use return on investment (ROI) to measure profits and losses compared to the principal invested. In other words, ROI is a rough estimate of the profitability of an investment. Using the investment principal as a reference, a positive return on investment (ROI) value represents profit, while a negative return on investment (ROI) value represents a loss.

Return on investment (ROI) calculations are not limited to trading or investing, but apply to all types of business or purchases. If you plan to open or buy a restaurant, you should also do the math first. Looking at it from a financial perspective, does opening a restaurant make sense? Calculating an approximate return on investment (ROI) based on all projected expenses and returns can help investors make more informed business decisions. If the business has a positive return on investment (ROI) and looks promising, it's worth taking the plunge.

In addition, return on investment (ROI) evaluates the benefits of completed transactions. For example, suppose you buy a classic car for $200,000, use it for two years, and invest $50,000 in the car. Imagine that the market price of this car now increases and it can be sold for $300,000. The owner not only enjoys the vehicle for two years, but also receives substantial investment returns. What are the specific benefits? Let's find out.

How to calculate return on investment (ROI)

The formula for calculating return on investment (ROI) is very simple. Subtract the investment principal from the investment's current value and divide the resulting value by the investment principal.

Return on Investment = (Current Value - Principal) / Principal

So, how much profit can you make from selling this classic car?

Return on investment = (300,000 - 200,000) / 200,000 = 0.5 

That is, the return on investment (ROI) is 0.5. Multiply this number by 100 to get the rate of return (ROR).

0.5 x 100 = 50

In other words, the return is 50% of the principal. However, to get the full picture, vehicle expenses also need to be taken into account. Subtract this from the current value of the vehicle:

300,000 - 50,000 = 250,000

Now, after subtracting the cost of the vehicle, calculate the return on investment (ROI):

Return on investment = (250,000 - 200,000) / 200,000 = 0.25

That is, the return on investment (ROI) is 0.25 (or 25%). In other words, multiply the investment cost ($200,000) by the return on investment (ROI) (0.25) to calculate the net benefit, which is $50,000.

200,000 x 0.25 = 50,000

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Limitations of Return on Investment (ROI)

Return on Investment (ROI) Easy to understand, it is a universal metric for measuring returns. Are there limitations? Of course there is.

One of the biggest limitations of return on investment (ROI) is the failure to consider the time horizon. Why is this important? Because time is the key factor in investing. There are of course other considerations, such as liquidity and security. However, an investment with a return on investment (ROI) of 0.5 in one year will be better than an investment with a return on investment (ROI) of 0.5 in five years. So you'll see people use the concept of annualized return on investment (ROI), which is the expected return on investment (earnings) within a year.

However, return on investment (ROI) does not take into account other aspects of investment. A high return on investment (ROI) does not necessarily mean a good investment. What if no one wants to buy the investment and it will be stuck for a long time? What if the underlying investment is illiquid?

Another consideration is risk. The potential return on investment (ROI) may be very high, but at what cost? If an investment has a high probability of being lost or the funds cannot be accessed, then the potential return on investment (ROI) does not matter at all. Why? Because the risk of holding assets for a long time is very high. Of course, the potential rewards are also high. However, investors certainly do not want to lose all their investment capital.

Studying return on investment (ROI) alone does not provide insight into security, so other metrics must be considered. First, the risk/reward ratio can be calculated for each trade and investment. This provides a better understanding of the quality of each investment. In addition, some stock market analysts also consider other factors when evaluating potential investments. These include cash flow, interest rates, capital gains tax, return on equity (ROE), etc.

Summary

We have looked at the concept of Return on Investment (ROI) and how traders should take advantage of it It makes smarter investment decisions. The return on investment formula is a core part of monitoring the performance of any portfolio, investment or business, etc.

As mentioned before, return on investment (ROI) is not an ultimate indicator, but it has its reference value. You also need to consider opportunity cost, risk/reward ratio, and other factors that will also affect your individual investment choices. However, return on investment (ROI), as an initial metric, can be a reliable barometer for evaluating potential investments.