Everyone who invests in any financial instrument does it with the objective of watching their money grow. Not just mutual funds, stocks or commodities, many measure their return on investment for any major decisions as well. Many who want to study abroad measure the ROI aspect of spending so much in education outside India; if their earnings after the education will cover up for the huge spends. ROI has become important in business decisions, capital purchases and investments or any other decision that requires a considerable chunk to be spent. ROI can be used by anyone from any walk of life.
It is a big deciding factor for understanding if an investment is worth it or not.
What is ROI?
In the context of financial investments, return on investment (ROI) means how much will your money grow if you invest in a particular stock or mutual fund or as the case may be. ROI can be calculated at different stages.
ROI can be used to get an idea of returns before investing anywhere, while one is in the middle of the tenure or after redemption, ROI can be used for equity and debt oriented instruments.
How to calculate ROI?
Return on investment is calculated to check how much returns has your investment generated. It can be calculated in percentage terms.
Return on investment can be calculated using the following formula:
ROI Formula: [(Final value of investment-initial value of investment)/initial value] * 100
Let’s understand this with the help of an example.
Say A invested Rs 80,000 in an equity mutual fund that became Rs 96,000 at the end of two years, let’s calculate the ROI for this.[(96,000-80,000)/80,000]*100
Here the return on investment is 20%.
Different investors can have different interpretations of how they want to calculate the returns from their investments. Some want to have a look at the annualised returns.
If we again consider the previous example.n 20% is the returns that ‘A’ receives cumulatively over a period of two years. Annualised returns how much did the investor’s money grow each year to reach the final investment value.
In this context, annualised returns will tell us how much has Rs 80,000 grown every year to become Rs 96,000 at the end of two years.
Annualised returns; [(1+ROI)^1/n – 1]*100 . The answer is expressed in percentage terms.
ROI: Return on investment
n: number of years
Here the ROI is 20% and n= 2
[(1+20%)^1/2 – 1]*100 = 9.5% approximately.
Here the annualised returns from the investment are around 9.5%.
ROI using calculators
Uses and Interpretation of ROI
Return on investment can be used for any investment. Be it traditional investments like fixed deposits or any other banking products, gold and other commodities, equities and bonds and any other market-linked products. ROI is one of the metrics that can be used to understand the performance of the investment.
ROI of any investment will be dependent on the various factors that impact the performance of that asset class.
Calculating ROI can be used to optimise one’s own financial investments portfolio.
Projected ROI can be calculated on the basis of historical returns or any other historical data before getting into an investment
Benefits and Limitations
Versatile: Return on investment (ROI) is an all-pervasive metric which is used for different purposes and not just investments in financial instruments. ROI is a versatile metric.
Easy to use: ROI calculation is easy to use and understand. This makes it an approachable metric for everyone. You don’t have to use complex tools or formulae to get an ROI on your investments.
Aids financial decision-making: ROI helps investors to get a better hold of their finances and get a faint idea of what to expect from the deployment of finances anywhere.
Does not account for inflation: One of the biggest limitations of ROI is that it does not take into account the factor of inflation. Considering the same example, Rs 80,000 may have risen to Rs 96,000 in absolute numerical terms. However, inflation, if it has risen considerably, reduces the value of money. So the 20% returns on investment may not necessarily mean that you can afford much more in absolute terms as well. Some of the best returns on investment account for all expenses and taxes.
Other expenses: ROI does not consider other expenses like investment cost, charges imposed by different investment platforms and any other extra charges that an investor has to incur.
Taxes: The returns that ROI calculation gives are not accounted for applicable taxes. So the figure you get at the end of the calculation may be lesser in real terms.