When you are advised to begin an investment, what do you understand by it? An avenue where you invest to earn some returns.
However, is it so simple? No!
Investing in the right avenues takes a lot of analysis and understanding of the investment vehicle. Moreover, understanding the jargons used is crucial. One such essential term that you need to be aware of is the return on investment.
What is Return on Investment (ROI)?
Return on investment, more popularly abbreviated as ROI, is a financial ratio used in calculating the income the investor will receive after investment in that particular avenue after a specified duration. Since the concept is based on returns, the higher this number, the better it is for the investors.
What is the mathematical way to determine ROI?
While there are many different ways to compute return on investment, here are two commonly used formulas-
Return on Investment (ROI) = Net Income / Cost of Investment
Return on Investment (ROI) = Gain in Investment / Base amount of Investment
Let us understand this using an example.
Say an investor invests ₹ 1,00,000 in ULIP where it grows to ₹ 1,60,000 over 14 months. Using the above formula, ROI is calculated as –
ROI = (1,60,000 – 1,00,000) / 1,00,000 = 0.6 or in percentage terms as 60%
Thus, the investor will see a growth of 60% over a 14 month tenure for its ULIP.
How can an investor use ROI?
Calculating ROI is one of the easiest ways to measure the return your investment will render. It can help the investor decide on which investment options to choose from. The calculations are indicative of how your investment is performing over its life. Further, a prudent investor can also switch or opt to move to a different investment in case the returns are too low when compared with similar offerings.
Using the ROI formula, the investor can make bifurcations for its investments that are performing as promised at the time of investment. Conversely, the low-performing investments can be closely monitored to ensure they are disinvested or switched when the returns hit a plateau.
What are the benefits of using the ROI formula?
The benefits of using the ROI formula are found not only in the offline world but also when making an online investment. Here are a couple of benefits that should be known by every investor.
- Simplicity: This metric is the most commonly used measurement estimate as it helps in comparing all the investment on the same scale. Here only two inputs are required, the returns in absolute terms and the original amount of investment. Using these two figures, one can measure the return on their investments consistently across every investment.
- Universal acceptance: The ROI metric of measurement is universally accepted. Any reference made using the terms ROI can be understood in uniformity by all.
Are there any limitations to the formula?
While its ease of computation gains popular acceptance, there are a few points worthy of noting while you use ROI as a comparison metric among your investments.
ROI does not account for time consistently: A higher ROI does not always mean a better alternative. One needs to consider for the time duration in which such investment has shown growth. Thus, ROI can be the same for two investments, but the time in which it is achieved can be different. Hence, financial advisors resort using the formula for Annualised ROI. Here all investments are equated to returns for an annual period and can be compared prima facie too.
ROI formulas can be different depending on the goals: Some investors may calculate the ROI considering the costs involved in investing, i.e. netting-off any expenses, whereas some others may account for it in vanilla terms. Thus, the formula is open for interpretation depending on the ultimate financial goal.
With the ease of carrying on financial investment over the web, it is a smart move for you to be aware of these terminologies to compare these metrics. Make sure you compute your return on investment when you are making an online investment and select the most suitable plan for yourself.