How to Measure Your Return on Investment
Using ROI to find investment success
An investor focuses primarily on one number—ROI or Return On Investment. It is the most important number.
ROI is a simple concept. If you invest “X” number of dollars, pesos, euros, or yen, how much money will “X” make, or return, to you? It’s a simple calculation:
The amount of money earned is called cash flow. It is also referred to as the yield, because it shows what the investment yields or produces.
Examples of ROI
Here are a couple of examples:
If you invested $1,000 in a stock that pays an annual dividend of $40, your return on investment would be 4%. ($40 / $1,000 = 0.04 = 4%)
If you put $10,000 cash as a down payment to purchase a $50,000 rental property with an annual positive cash flow of $1,500, your ROI would be 15% ($1,500 / $10,000 = 0.15 = 15%).
This is also called a cash-on-cash return. To me, the cash-on-cash return is the most important number because it tells you exactly what your invested money is earning. In other words, it tells you how hard your money is working for you.
These two examples of stock dividends and rental property are cash-flow investments. But ROI also applies to capital-gains investments. For example, if you purchase a share of stock for $20 per share and the stock price goes to $30, after fees and expenses are deducted, your profit or yield would be $5. Your ROI in that case would be $5 / $20 = 0.25 = 25%.
You may also hear the term Internal Rate of Return (IRR), which is a bit more complicated.
IRR takes into account the present value of money. The present value of money is the idea that $1 today is worth more than $1 in one year. IRR also assumes that the cash flow or yields you are earning are all reinvested immediately and are reinvested at the same rate of return (which is rarely, if ever, the case). One calculation for IRR is:
And this equation is precisely why I do not use IRR as a measure for my money. It’s too complicated.
I prefer to use a cash-on-cash return on investment. If you want to understand the internal rate of return more fully, then you may want to research it online. Knock yourself out.
Caution: When someone is pitching you on investing in their deal, be sure to define if the return on investment they are stating is a cash-on-cash return or an internal rate of return. They are very different when it comes to your bottom line.
What Is a Good ROI?
It depends. It depends upon the type of investment. It depends upon the economy. It depends upon your financial intelligence.
Back in 1979 and 1980, I remember my parents talking about the rate of return they were getting on their bank’s certificates of deposit (CDs). It seemed normal at the time, but their rate was 18%. Who wouldn’t like an 18% return on a CD today? What I found really interesting though was when the savings-and-loan crisis hit in the 1980s. The bank retracted the 18% interest rate and basically cancelled the outstanding CDs. If an individual had done that, lawsuits would have followed!
With little financial intelligence, you can typically expect a low return on your investments. Why? Because you won’t know what to look for in investments that generate higher returns and will probably end up in investments or savings plans that offer low yields.
This is why financial planners recommend mutual funds, CDs, and savings to people with little money know-how. This is also why so many people get taken in when they are promised too-good-to-be-true returns on investments they know nothing about.
Obtaining and sustaining a high rate of return takes financial education and experience. There is no secret sauce, no magic pill. It takes putting in the time and effort to study, research, and then take action.