How to Calculate Rate of Return on Investment (ROI)
It’s easy to stick money in your retirement fund and forget about it. But that doesn’t mean you should! As important as consistent saving is understanding your rate of return on investment (ROI). If you’re not beating the market, you’re losing money. You can’t know where you stand against the average without the ability to calculate ROI.
The good news is that calculating ROI is simple. You can do it in seconds using our calculator. And while a calculator makes it easy to monitor your rate of return, it’s still important for investors to understand exactly what that means. Below, we’ll go through everything you need to know about ROI. We’ll also give you some great tips for how to evaluate portfolio performance so you can capitalize on the best possible ROI.
What Is ROI?
The concept of ROI is very simple and straightforward. At its most basic level, it’s a question: Did you make money on an investment? If the answer is yes, you have a positive ROI. But it goes deeper than that – specifically, how much was your return? To discern this, investors need to understand a very basic formula…
ROI = (Current Value – Cost of Investment) / Cost of Investment
In plain English: Take the value of your investment, subtract what you paid for it, and divide the difference by the original cost. The result is your rate of return on investment. The higher this number, the better your rate of return. (You can also multiply it by 100 to turn it into a percentage.)
But this isn’t all there is to ROI. What many new investors don’t realize is that hidden factors within each investment can sway your rate of return. To truly understand ROI, you need to know the underlying factors that affect it.
Factors Affecting ROI
Most investors look at ROI from a transactional standpoint – which is what the above formula shows. Unfortunately, there is a slew of additional factors to consider, including…
- Transactions costs (e.g., brokerage fees)
- Taxes (e.g. capital gains tax)
- Opportunity cost (what assets outperformed your investment).
Each of these overlooked factors takes a chunk out of ROI. For example, say you paid $100 for an investment that’s now worth $200. Your ROI appears to be 100% – you doubled your money. But factor in a $4 transaction fee to both buy and sell the security, then consider how long it took that security to appreciate 100%. If it took 10 years, your annualized rate of return is just over 7%, which is likely less than the market average.
Calculating ROI is a good benchmark for performance, but it’s not an ultimate representation of your rate of return. To get a true picture of ROI takes a much more complex equation. For example, an ROI equation that takes time into account looks like this: [(1+ROI)1/n – 1] × 100, where n is equal to the number of years you held the investment. For this equation to work, ROI must be expressed as a decimal, not a percentage.
Measuring ROI Through Different Lenses
If you haven’t guessed by now, ROI is a static number for dynamic investments. That means there are multiple ways to look at it:
- Net Income: This is the simplest measure of ROI, which measures value increase.
- Capital Gain: This is the measure of return on realized gains after taxes and fees.
- Total Return: ROI that includes interest, capital gains, dividends and distributions.
- Annualized Return: The rate of return over time, represented by an annual average.
Each of these measures offers investors different insight into their rates of return on investment. For example, if you want to know your ROI at a glance, net income works just fine. However, if you’re getting ready to exit a position you’ve held for 20 years, you’ll want to know the implications of taxes, dividends and distributions, making total return a better measure.
The Limitations of ROI Calculations
The biggest drawback of ROI is that it’s limited in what it can tell you about your investments. For example, your portfolio might show great ROI, but that doesn’t tell you which individual assets are behind that return. Deeper analysis might show you that 60% of your investments are actually underperforming the market, while 40% are responsible for your high rate of return. Such is the case with the S&P 500 and other major indexes.
ROI calculation also fluctuates alongside the market. If the market goes down this week, your ROI will also likely drop. If it goes up, your rate of return will rise as well. Thus, spot-checking rate of return isn’t always a good temperature check. The best way to gauge true ROI is to calculate over time and observe a trend line.
Finally, ROI is manipulable. If you sell your portfolio’s low-performing assets, you’ll immediately boost its ROI. If you take profits on an overperforming stock by culling your shares, you’re cashing out real value for theoretical ROI moving forward. It’s safe to say ROI measurements are best taken with a grain of salt.
Get a Clear Picture of Your Investments
Getting a handle on the rate of return on investment (ROI) gives you power over your investments and your retirement. Sign up for the Wealthy Retirement e-letter below to learn how you can retire on your own terms.
For example, if your current portfolio ROI is 11% and the S&P 500 shows gains of 13%, it’s a sign you might need to change your allocation. Or, if you’re getting ready to sell an asset, you might want to offload negative ROI stocks to offset capital gains. Above all, understanding the rate of return helps you feel comfortable about your investment prospects—or correct them if they’re coming up short.