Acting in the financial market requires considering a variety of different key metrics. Return on investment (ROI) is one of them. It is widely used when a trader needs to measure the chances of gaining a fast and positive return from the investment. In other words, the metrics make it possible to compare potential profit or loss based on the initial instrument cost.
Another good thing about the metrics is the fact that it can be used either to measure the return in reference to a stand-alone or several investments. Besides, it helps to clarify the attractiveness of various investment alternatives, compare and contrast them, and finally choose the one with higher ROI perspectives. In this article, we will show how to make the necessary calculations and evaluate your possible return.
Explaining the Return on Investment
Before we learn how to calculate the ROI, we need to interpret the term making it easy for traders to understand how it actually works. Let's stress out two major issues of the metrics:
- First of all, ROI is generally expressed as the percentage but not a sum. It makes it easier for investors to understand what to expect in terms of return.
- Secondly, when calculating ROI, you should also consider the net return in the numerator taking into account the return could be either negative or positive.
What Does the Positive and Negative ROI Mean?
A positive figure means when calculating ROI means that the net return is in the black. It means a potential profit, as the total return is very likely to exceed the initial cost of the stock or another trading instrument.
A negative figure means that the net return is in the red. In other words, it can be associated with a potential loss, as the initial cost is higher than the total return.
To make the calculations as accurate as possible, we need to take into account both total costs and returns. This is where a so-called apple-to-apple comparison can work when identifying the best option between two or more competitive investment alternatives.
Methods to Calculate ROI
To calculate ROI, you may opt for two different methods:
ROI Pros and Cons
Now when you know how to calculate your Return on Investment, let's have a closer look at its possible advantages and disadvantages for the trader. On the one hand, the metrics are simple to calculate and consider when choosing an ultimate instrument to trade or invest. On the other hand, it is necessary to consider some other metrics such as timeframes, holding periods, etc.
The first and foremost benefit is the fact that the metrics are pretty easy to calculate. We have already learned two major methods to handle the task. Besides, the metrics are not as hard to understand, as it may seem from the start. It means that traders can use it as the general tool to measure the instrument's profitability. What's more, it is impossible to misunderstand ROI, as the calculations are very clear.
Despite all simplicity that comes with ROI calculations, traders may come across some stumbling blocks, especially in the long run.
- The metrics do not consider investment holding periods. This fact may appear to be a challenge for traders who try to figure out the best trading alternative without knowing the particular timeframe. Here is an example: we have an X investment alternative with a potential ROI of 25% on the one hand and an investment Y alternative with ROI of 15%. It seems like option X is more appealing in terms of return. However, ROI for investment Y can be generated over the years, which means stability and easiness to predict, while ROI for investment Y has been generated only for the last few months. So, the timeframes are always to consider.
- Another problem is the inability of the metrics to adjust for risks. You need to clearly understand that ROI comes with a direct correlation with risk. If you look for the highest potential returns, the risks also increase drastically. In other words, an investor holding a 12% ROI portfolio deals with greater risks if compared to the investor holding a 4% portfolio. It also means that the total outcome can be different as well.
- Last but not least, ROI refers to the category of profitability metrics. It only emphasizes financial profits and potential gains. The main disadvantage here is that it does not take into account ancillary benefits (environment or social products). For these types of goods, investors usually opt for Social ROI – a relatively new metrics.
On the one hand, traders and investors have simple and easy-to-calculate metrics that help to define potential profitability. On the other hand, it comes with some limitations and aspects to take into account. It does not consider holding periods as well as it cannot adjust for the risk. Nevertheless, the Return on Investment is still the fundamental metrics that can be applied to figure out the investment rank as well as compare and contrast several investment alternatives. Although, it's not the only thing a trader should consider planning a strategy. Read also about correct forex position sizing.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.