ROI (Return on Investment)
In this article, we'll learn how to calculate ROI, which is surprisingly not quite as simple as it seems. Although it's not the most exciting topic to read about, a solid ROI will allow you to retire well. A poor ROI forces you into a very frugal lifestyle with little to no philanthropic opportunity. Easy choice.
However, consider this:
A great ROI will allow you to travel Europe, put your great-great grandchildren through college and make donations to the charity or political cause of your choice, Getting a great ROI will improve your quality of life tremendously.
Why does ROI matter?
ROI is crucial to your quality of life once you begin tapping your retirement assets. Consider this:
Let's pretend you make a $10,000 investment at age 25 (or perhaps you put $10,000 investment into your child's account). Let's assume we wait 40 years.
At a 5% ROI, the balance is now $70,400
At 6%, it goes to $102,860
What about 7%? Now you're looking at $150k, double that of 5%
Push it to 10% and you get a balance of $450,000. That's with NO ADDITIONAL investment at all.
Use larger numbers and regular deposits and the importance of ROI becomes very apparent.
Retiring with a $3 million nest egg and retiring with a $30m nest egg could literally just mean squeezing an extra 1 or 2 % out of your returns.
How to Calculate ROI
In order to calculate your ROI, it's simple. We take your exit amount and divide it by your entry amount and subtract 1.
ROI = (capital out / capital in) - 1
Say you invest $1,000 to enter a position. You exit that position later for $1,200.
$1,200 / $1,000 = 1.2
1.2 - 1 = .2
.2 = 20% ROI
Return on Risk: A Better Metric?
Calculating ROI is helpful. It gives a sense of how much return you achieved with your capital. Return on risk is another measure that's useful in evaluating your investment decisions
ROR = (return / risk) - 1
Example: You enter a position @ $100 per share. You plan to exit if it falls below $80 per share. You exit at $110 per share with a successful trade.
Your return on risk is 50%
$10 return / $20 risk = 50%
Note that Return on Investment is 10% and Return on Risk is a very different 50%.
To ROI or to ROR, that is the question.
For longer-term investors, ROI is the preferred metric (and preferably with a risk-adjustment metric like a Sharpe or Sortino Ratio to compare investment risk profiles).
For short-term traders, ROR is more appropriate, since capital isn't tied up for very long.
Both have their place in the investment world, so choose whichever makes the most sense to you.
Feel free to leave your thoughts below. Do you prefer ROI or ROR? Why?