Résumé

ROI is a way of measuring the performance of an investment. As you imagine, it is also a great way to compare the profitability of different investments. Naturally, an investment with a higher ROI is better than an investment with a lower (or negative) ROI. Want to know how to measure this for your own portfolio? Let's see it together.


Introduction

Whether you are a day trader, swing trader, or long-term investor, you should always measure your performance. Otherwise, how would you know if you are good or not? One of the great advantages of trading is that you can rigorously measure your performance with objective metrics. This can greatly help eliminate emotional and cognitive biases.

So how is this useful? Well, the human mind tends to create narratives around everything while trying to understand the world. However, you can’t “hide” when it comes to numbers. If you are producing negative returns, something needs to change in your strategy. Likewise, if you feel like you're doing well but the numbers don't reflect it, you're probably a victim of your biases.

We have already discussed risk management, position sizing and setting up Stop-loss. But how do you measure the performance of your investments? And how can you compare the performance of multiple investments? This is where calculating ROI comes in handy. In this article, we will see how to calculate return on investment (ROI).


What is return on investment (ROI)?

Return on investment is a way of measuring the performance of an investment. It can also be used to compare different investments.

There are several ways to calculate returns, and we'll cover some of them in the next chapter. For now, however, it is enough to understand that ROI measures gains or losses relative to the initial investment. In other words, it is an approximation of the profitability of an investment. Compared to the initial investment, a positive ROI represents profits and a negative ROI represents losses.

Calculating ROI applies not only to trading or investing, but also to any type of activity or purchase. If you're thinking about opening or buying a restaurant, you need to do some math first. Will opening make financial sense? Calculating an estimated ROI based on all your expenses and expected returns can help you make better business decisions. If the business looks like it could ultimately be profitable (i.e. have a positive return on investment), it may be worth launching.

Additionally, ROI can help you evaluate the results of trades already made. For example, let's say you buy an old exotic car for $200,000. You then use it for two years and spend $50,000 on this project. Now suppose the price of the car increases in the market and you can now sell it for $300,000. Not only did you enjoy this car for two years, but it also gave you a significant return on your investment. How much does that represent exactly? Let's see it together.


How to calculate return on investment (ROI)

The ROI formula is quite simple. You take the current value of the investment and subtract the initial cost of the investment. Then you divide this sum by the initial cost of the investment.

ROI = (Current value - Initial cost) / Initial cost

So how much profit would you make by selling the exotic car?

ROI = (300 000 - 200 000) / 200 000 = 0,5

Your ROI is 0.5. If you multiply it by 100, you get the rate of return (ROR).

0,5 x 100 = 50

This means that you have added value of 50% on your initial investment. However, you have to take into account the amount spent on the car in order to get the whole picture. So, we're going to subtract this from the current value of the car:

300 000 - 50 000 = 250 000

You can now calculate the return on investment while taking into account expenses:

ROI = (300 000 - 250 000) / 200 000 = 0,25

Your ROI is 0.25 (or 25%). This means that if we multiply your investment cost ($200,000) by your ROI (0.25), we can find the net profit, which is $50,000.

200 000 x 0,25 = 50 000


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The limits of ROI

Return on investment is therefore very easy to understand and is a universal measure of profitability. Are there any limits? Of course.

One of the main limitations of ROI is that it does not take time into account. Why is this important? Time is a crucial factor for investments. There may be other considerations (like liquidity and security), but if an investment generates an annual ROI of 0.5, that's better than a ROI of 0.5 in five years. This is why some talk about annualized ROI, which represents the investment returns (earnings) you can expect over the course of a year.

However, ROI will not take into account other aspects of an investment. A higher ROI does not necessarily mean a better investment. What happens if you can't find anyone willing to buy your investment and get stuck for a long time? What happens if the underlying investment has low liquidity?

Another factor to consider is risk. An investment can have a very high potential return on investment, but at what cost? If there is a good chance that it will go to zero or your funds will become inaccessible, the potential ROI is not that great. For what ? The risk of holding this asset for a long time is very high. Of course, the potential reward can also be high, but losing the entire initial investment is definitely not what you want.

Simply studying ROI will not give you information about the safety of an investment. You must therefore also take other indicators into account. You can start by calculating the risk/reward ratio for each trade and investment. This way you can get better visibility of the quality of each bet. In addition, some stock analysts may also consider other factors when evaluating potential investments. These could be cash flow, interest rates, capital gains taxes, return on equity (ROE), etc.


To conclude

We looked at return on investment (ROI) and how traders can use it to make more informed investment decisions. The ROI formula is an essential part of tracking the performance of any portfolio, investment, or business.

As we have seen, ROI is not the ultimate indicator, but it can be useful. You should also consider opportunity cost, risk/reward, and other factors that may impact your choice between different investment opportunities. To begin, however, ROI can be a good barometer for evaluating a potential investment.