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A smart investor’s guide to Calculating Return on Investment (ROI)

Return on Investment

Every investment is made to earn a return. Tracking performance regularly is necessary. It is more relevant to market-driven investments like mutual funds. Return on Investment (ROI) is one metric that’ll help in understanding the performance of an investment.

What is Return on Investment?

Every investment is made with a purpose. One way to check whether the investment is achieving the target is by checking potential returns. Understanding the potential gains will help in deciding whether or not to invest in the asset class. Checking the historic ROI will help in understanding the performance trend of the asset.

When an investment delivers promised returns, it is considered to be an excellent investment option. ROI is relevant for both equity and fixed income instruments. It is a profitability ratio. ROI can be used for comparing investments. ROI helps in understanding the return from an investment and optimize the investment portfolio.

Return on Investment Formula

Return on Investment formula is simple and straightforward. ROI is expressed as a percentage of increase or decrease in the value of the investment. Either of the following two formulas can be used to calculate ROI:

ROI = (Net Return on Investment/Cost of Investment)*100

(OR)

ROI = [(Final Value of Investment – Initial Value of Investment)/Cost of investment]*100

How to Calculate Return on Investment?

Return on investment (ROI) is a metric to measure the profitability of an investment. It measures the gain of an investment over and above the investment cost. It is a simple ratio of profit of the investment relative to the cost of the investment. ROI is expressed as a percentage, and hence it is easy to compare with the profitability of other investments.

ROI can be calculated using either of the two formulas. Let’s take an example of Mr. Anurag, who has invested in INR 50,000 in a mutual fund scheme. Three years down the line, at the time of redemption, the value of the investment is INR 80,000. The return on investment for Anurag can be calculated using the above two formulas.

ROI = (Net Return on Investment/Cost of Investment) *100%

Net Return on the investmentINR 30,000 (80000-50000)
Cost of the investmentINR 50,000
ROI60% ((30000/50000)*100%)

ROI = ((Final value of Investment-Initial value of investment)/Cost of investment)*100%

Final value of the investmentINR 80,000
Initial value of investment or cost of the investment INR 50,000
ROI 60% ((80000-50000)/50000)*100

The cost of investment is similar to the initial investment. The return on investment is 60%. This can be easily compared to other investments, which will help in decision making. But mutual fund’s return is stated as an annualized, and the above return is absolute return.

Annualized return can be calculated using the following formula:

Annualized return = [(1+ROI)1/n – 1]*100%, where n is the number of years the investment is held.

Hence the annualized return for Mr Anurag is [(1+60%)1/3 – 1]*100% = 16.96%. This 16.96% is the annualized return. This means the investor, on average, earned a 16.96% return each year for three years. Hence the investment grew from INR 50,000 to INR 80,000.

Advantages & Disadvantages of Return on Investment

Advantages of Return on Investment

  • User-friendly: Calculation of ROI is straightforward. All that an investor needs to know is the cost of investment and profit amounts. To calculate ROI, it doesn’t require the help of any financial expert.
  • Widely used and understood: The ROI formula is used across the world. It is a universally accepted concept. ROI is easy and simple to interpret and explain to people.
  • Versatile: ROI is a simple but effective parameter to make an investment decision. It has many applications such as understating profitability of a scheme and for comparative analysis, among others.

Disadvantages of Return on Investment

  • Ignores the time value of money: Different schemes have different maturities and tenures. ROI of a one-year Fixed Deposit cannot be compared to a three year ELSS. The rate of return is a performance metric.
  • Doesn’t consider Inflation: ROI doesn’t take into consideration the reduced value of money due to inflation and additional expenses like processing fee, stamp duty, etc.
  • Results are easy to Manipulate: Results vary from investor to investor. Therefore, only when the same inputs are used, the exact value can be determined.

Frequently Asked Questions on Best Return on Investment?

Why is return on investment important?

Return on Investment (ROI) is a key performance indicator (KPI) used by businesses to measure profitability and make essential decisions for running the business. Every business and individual investors invest for something in return. To know if they are earning something is measured by ROI. If not, corrective actions can be taken to secure the needed return. Hence ROI is an essential indicator for individuals and businesses.

What is a good return on investment ratio?

It is not very easy to specify a certain percentage as a good return on investment. This is because each individual is different. Their expectations from their investments vary from each other. While one cannot say what ratio is good, but yes, inflation-beating returns are something that investors must look at. Any performance beating inflation is excellent. Also, the higher the ROI better is the investment. Investors can compare ROI’s of multiple investments before taking a call whether to invest or not.

How to find out annual return on investment?

Annual return on investment is the return from an investment over a period of time. It is a measure of how an investment performed over a period of time. Annual ROI can be calculated using the formula [(1+ROI)1/n – 1]*100%, where n is the number of years the investment is held.

Published on March 13, 2020
Mohankumar Swaminathan
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