ROI calculation: Practical guide to assessing your investments

What you need to know: If you want to measure the performance of your investments objectively, it is important to be able to calculate your return on investment (ROI). This tool helps you compare the profitability across different options and eliminate emotional biases from your decisions.

Why is investment return so crucial?

As a trader or long-term investor, you cannot just rely on gut feelings. Whether you are trading daily or holding positions for longer periods, you need objective numbers to assess how things are going. People tend to create stories around their results – whether they are positive or negative.

Here lies the strength in calculating ROI. With objective measurements, you can identify what works and what doesn't. If your numbers show negative results, it's time to adjust strategy. And if you feel successful, but the numbers say otherwise, there are likely some cognitive biases you need to work on.

How to Calculate ROI – the Formula that Works

The formula to calculate investment return is straightforward:

ROI = (Final Value - Start Costs) / Start Costs

Let’s take a concrete example. You buy a classic sports car for 200,000 USD. Over two years, you spend 50,000 USD on maintenance. The market price rises, and you can sell it for 300,000 USD.

Without considering expenses:

• ROI = (300.000 - 200.000) / 200.000 = 0.5 or 50%

But when you include the 50,000 USD you used:

• Adjusted value = 300,000 - 50,000 = 250,000 USD
• ROI = (250.000 - 200.000) / 200.000 = 0.25 or 25%

This means that your net gain is 50,000 USD (200.000 × 0.25).

ROI calculation is used everywhere – not just in trading

Many believe that investment returns only concern the stock market or cryptocurrencies. But that is not the case. Imagine you want to open a restaurant. Before you invest resources, you should calculate what your expected ROI will be. If the numbers show a positive return, it is a green light to get started. If they point in the other direction, you save yourself from a bad choice.

The ROI calculation can also be used retrospectively – to analyze how a previous investment has performed.

Important limitations you should know

Although ROI is a powerful tool, it has its weaknesses:

Time Period is Ignored: An ROI of 50% over one year is better than 50% over five years. When you see people's numbers, always ask: over what time period? Some mention annual returns, which normalize results over 12 months.

Liquidity is not addressed: What if you’re stuck with the investment because no one wants to buy it? A high ROI doesn’t mean much if you can’t realize the profit.

Risk is ignored: An investment with potentially enormous ROI can be extremely risky. If there is a high probability of losing everything, the high potential return is worth less. Therefore, you should also consider the risk-reward ratio for each position.

Other factors omitted: Analysts also consider cash flows, capital gains tax, return on equity, and more. ROI alone does not provide the full picture.

How to navigate around the limitations of ROI

To get a more nuanced assessment of your investments:

• Calculate annual ROI – this makes the results comparable
• Evaluate the risk-reward ratio – high ROI with high risk is not necessarily better than moderate ROI with low risk
• Consider liquidity – can you realize your gains at any time?
• Analyze opportunity costs – what could you have done with the money instead?

Conclusion: ROI as Your First Tool

The ROI calculation is not the only tool you should use, but it is a good starting point. By systematically calculating ROI for your investments, you can make more informed decisions and reduce emotional influence on your choices.

Remember: a good investment is not just about achieving the highest possible ROI, but about balancing returns with risk, liquidity, and your personal goals. Use ROI as one measure among many, and you will gain a clearer picture of your portfolio's health.