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What Should You Aim for in ROI? And Mistakes to Avoid

Are you looking at all the angles with your investments? Let's take a look at the ROI calculation and others and go into what you should avoid.

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This story originally appeared on MarketBeat

I just helped my daughter invest in a robo-advisor the other day (in my name, of course), because she's eight. 

Depositphotos.com contributor/Depositphotos.com via MarketBeat

I showed her a chart that explained how much she'd earn if she kept her money in the market for 40 years. Needless to say, she's anxiously anticipating her teensy investment to balloon to $1 million. 

"Not so fast," I chuckled. "Let's let compound interest kick in for a while." 

Then I launched into an explanation of ROI. She listened politely for a few seconds, then wandered off to watch TV. (Someday it'll stick.)

If you're like my daughter (or me), you may have already experienced the agonizing crawl of watching your portfolio grow like a box turtle. Do you ever do calculations to figure out how your investments perform for you on the backend? For example, do you ever calculate ROI and IRR to give you a more comprehensive picture of your investments? Let's explore.

What is ROI? 

Return on investment (ROI) measures how much you may gain or have gained from an investment. It compares the gain or loss from an investment relative to its cost. Stock market investors can use ROI to calculate their return on investment in order to determine profit or loss compared to the cost of their portfolio. ROI tells how profitable investments are and lets you compare future investments for potential growth.

Let's take a look at a quick example.

Let’s say you invested $10,000 in a company and sold your shares for $10,500 six months later. Here’s how you would calculate your ROI for this investment:

ROI = ($10,500 – $10,000 / $10,000) x 100

ROI = (Present Value – Initial Investment / Initial Investment) x 100

You can use these costs to determine how well your investments performed. Seems so simple, right? However, it's easy to skip this angle when you invest. You may simply look at returns and forget about how much you gain or lose relative to initial cost.

What is a Good ROI? 

Naturally, you want the highest ROI possible. However, it still depends. Realistically, the right ROI for you might not match the benchmark return. Let's explain why in just a second.

You'll typically see an average annual return of 7%, based on the S&P 500 — at least when you take inflation into account. However, as with anything in the stock market, you'll face higher and lower returns over time. 

But the average annual ROI for your investment strategy may be different from the benchmark because of the level of risk or the asset class of that particular investment. You need to ask yourself several questions before you can determine the "right ROI" for you:

  • How much risk do I feel comfortable with?
  • Can I afford to lose money with this investment?
  • How much do I need to make with this investment?
  • Are there alternative investments that make more sense for my risk tolerance?

What makes sense for one person in terms of ROI might not make sense for another.

ROI Mistakes to Avoid

Take a look at these common ROI mistakes. 

Mistake 1: A simple ROI calculation doesn't take investment time into account.

ROI doesn't account for the time you spend investing in a particular investment. For example, it doesn't consider how long you hold an investment. This particularly applies to longer-term investments that take more time to become profitable.

Mistake 2: An ROI calculation can limit you. 

Have you considered using an internal rate of return (IRR) instead? Probably not, because it introduces a much more complicated calculation. (You just want to use the IRR or XIRR function in Excel or another program that can help you with these kinds of complicated financial metrics.)

However, an IRR calculation offers a more comprehensive view of an investment. It calculates the annual growth rate of the investment and takes into account the time value of money. 

ROI cannot do that — it simply gives the overall picture of the investment and its returns from beginning to end.

IRR can also help you estimate how profitable an investment may end up being for you. For example, let's say an investment has an 11% IRR. This means that this particular investment will return an annual 11% rate of return over its life.

When you apply it to expected cash flows from an investment, the IRR produces a net present value (NPV) of zero. (IRR gives the yield on an investment (as a percentage), while NPV is the present value of the investment.) 

Ultimately, using IRR can help you, as an investor, decide which one type of investment to invest in on the front end.

Why Use ROI?

Okay, all these complicated formulas. Why? (And seriously, cue a sleepy head bob or turn to the TV, like my daughter did during my attempt to share.)

The point of all of this is that ROI (and other calculations) allow you to feel more secure in what you've invested in.

However, as we discovered at a very, very basic level, you don't want to use ROI as the only formula when you want to make specific decisions about your investments. Again, ROI does not account for risk or time horizon. It also requires an exact measure of all costs. But life is fuzzy, and our investments aren't linear.

Using ROI gives you a great place to start when you're ready to evaluate any type of investment (whether that's real estate, business expenditures, stocks, etc.) but remember that it doesn't cater to everything.

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