Return on Investment

Maximizing your return on investment (ROI) is key to sustainable profitability. To measure the efficiency of an investment, simply compare the amount invested with the amount generated – that's the ROI!

What is Return on Investment?

ROI is a popular metric due to its versatility and simplicity. Essentially, ROI can be used as a straightforward indicator of an investment's profitability. This could be the ROI of a stock investment, the expected ROI for a company expanding a factory, or the ROI achieved in a real estate transaction.

The calculation itself is not too complicated and it is relatively easy to interpret for its wide range of applications. If the ROI of an investment shows a positive balance, it is probably worthwhile.

However, if other opportunities with higher ROIs are available, these signals can help investors select or eliminate the best options. Similarly, investors should avoid negative ROIs, which indicate a net loss.

These two key figures (ROI and net loss) are important indicators of the capital invested in an investment, representing profitability.

How do you calculate the ROI?

To calculate the return on investment, divide the amount you have earned from an investment—also called net profit—by the cost of the investment minus its present value, and multiply the result by 100. The result should be expressed as a percentage. There are two ways to represent this formula:

• ROI = (Net profit / Investment costs) x 100
• ROI = (Present Value – Investment Costs / Investment Costs) x 100

Let's say you invested CHF 5.000 in company XYZ last year and sold your shares this week for CHF 5.500. Here's how you would calculate your ROI for this investment:

• ROI = (CHF 5.500 – CHF 5.000 / CHF 5.000) x 100

Your return on the total capital you invested in company XYZ would be 10%. This simple example does not include capital gains taxes or fees associated with buying or selling the shares, but a more realistic calculation would incorporate these into the cost of the total capital.

The percentage figure provided by the calculation is the great strength of the return on investment (ROI). Instead of a specific amount in Swiss francs, you can take this percentage and compare it to the ROI percentage of other investments in different asset classes or currencies to determine which offers the highest return.

For example, the return on capital of a stock investment in a particular company can be compared with the return on capital of other examples of stock investments in other companies in the same industry.

What does a good return on investment look like?

Generally, an annual return of around 7% or more is considered a good return for an investment in stocks. This also roughly corresponds to the average annual return of the S&P 500, taking inflation into account.

Since this is an average value, your return may be higher in some years and lower in others. But overall, the performance will roughly settle at this amount.

To determine the right return for your investment strategy, you need to consider your options carefully and not rely on a simple guideline. The S&P 500 may not be suitable for the level of risk you are willing to take or for the asset class you are investing in. To calculate the appropriate return for you, ask yourself the following questions:

• How much risk can I afford?
• What will happen if I lose the invested money?
• How much profit do I need from this investment to accept the prospect of losses?
• What else could I do with this money if I didn't make this investment?

Benefits of ROI calculation

Using the profitability ratio offers many advantages that all analysts should be aware of.

Simple and easy to calculate

The return on investment (ROI) metric is frequently used because it is so easy to calculate. Only two figures are needed – the benefits and the costs. Since the term "return" can mean something different to everyone, the ROI formula is easy to use because there is no strict definition of "return".

Universally understood

Return on investment is a universally accepted concept, so it is almost guaranteed that people will know what you are talking about if you use this metric in conversations.

Limitations of the ROI formula

Although the metric is often very useful, there are also some limitations to the ROI formula that one should be aware of. Below are two important points worth considering.

The ROI formula neglects the time factor.

A higher ROI figure doesn't always mean a better investment opportunity. For example, two investments have the same 50% return. However, the first investment takes three years to complete, while the second takes five years to achieve the same return. The identical return for both investments might seem misleading, but when the time factor is considered, the investor can easily identify the better option.

This person must compare two instruments over the same period and under the same circumstances.

The ROI formula can be susceptible to manipulation.

An ROI calculation will differ between two people depending on which ROI formula is used. Marketing managers can use the real estate calculation explained in the example section without considering additional costs such as maintenance expenses, property taxes, sales fees, stamp duties, and legal fees.

Investors must consider the actual return on capital, which takes into account all possible costs incurred when the value of the respective investment increases.

Factors that affect your return on investment?

1. Market situation: The return on your investment is significantly influenced by the state of the market (ROI). The prospects for successful investments and the expected returns are affected by economic cycles, interest rates, and inflation.
2. Investment plan: Your ROI will also be significantly influenced by the chosen investment strategy. The risks and potential returns of different tactics vary.
3. Time horizon: The duration of the investment period will also directly influence the return on the investment. Longer time horizons typically offer an investment more room for growth or depreciation, which will have a greater impact on the overall return.
4. Risk tolerance: Another factor that will influence the return on the investment is risk tolerance. Investors with a higher risk tolerance may be more willing to accept larger potential losses in exchange for higher returns.
5. Fees and costs: Fees and costs associated with investments, such as commissions and management fees, can directly impact returns. While lower costs can increase potential returns, higher fees can reduce overall returns.

How do you achieve a good return on investment?

Investors can employ a variety of tactics to achieve a good return on their investment.

1. Invest in a diversified portfolio: This allows you to spread your risk and improve your chances of a high return on your investment. Diversification can be done both within and across asset classes, such as stocks, bonds, commodities, and real estate.
2. Develop a long-term investment strategy. Compared to short-term investments, long-term investments have the potential to generate better returns. You can reduce the impact of market fluctuations and benefit from the power of compound interest by using a long-term investment strategy.
3. Monitor your investments: To achieve a decent return on your investments, regular monitoring is essential. You can improve your approach to maximize your returns by tracking changes in the market, your assets, and other factors.
4. Take advantage of tax benefits: By taking advantage of tax benefits, you can improve your return on investment. Long-term, tax-advantaged investments, such as retirement plans and savings accounts, can help you keep more of your money.
5. Seek expert advice: By seeking advice from a certified financial advisor, you can get the most out of your investments. A financial advisor can guide you on how to maximize your return on investment and assist you in creating a customized investment strategy.

Which industries have the highest returns?

Historically, the average ROI for the S&P 500 has been approximately 10% per year. However, there can be significant fluctuations within this range, depending on the industry. For example, in 2020, many technology companies generated annual returns well above this 10% threshold. Conversely, companies in other sectors, such as energy and utilities, achieved much lower ROIs and, in some cases, faced losses year after year.

Over time, it is normal for the average ROI of an industry to change due to factors such as increasing competition, technological changes, and shifts in consumer behavior.