How to Calculate Return on Investment (RoI)?

After looking at the pros and cons of the investment plan, we finally decide to go ahead with “investing” and start to have an annual chart to ensure we are on the “right track of our smart investment plan”. But after all this, do we really know to calculate the returns on our investment? I mean the “correct way”? 

Before getting into the calculation methods and formulae, let us first understand the meaning of investment returns.

What is “Returns on investment”?
Returns on Investment (ROI) is the loss or gain of the investment asset for a particular period of time which is usually calculated in percentage. “More risk, greater the potential for higher return or loss”.
Two basic Components in ROI are:
1. Appreciation / Depreciation (increase/decrease in the investment value)
2. Interests and Dividends (generated income by the investment)

Is it important to know how to find the ROI?
Yes. It is very much important for you to know how to find the ROI for the following reasons:
          You need to “determine the ROI” to be sure that you are on the right track and make the required adjustments (when necessary)
You need to “estimate the ROI” to help you choose the right investment plans (more than one)

Different types of returns
There are different types of returns on investment which are mostly categorized by the term period.
1. Absolute return
2. Simple annualized return
3. Average Annual return (AAR)
4. Compound Annual growth rate (CAGR)

1. Absolute return

• It is the percentage increase or decrease an investment achieves over a period of time.

Absolute return = ((gain in investment – cost in investment) / (cost in investment))*100

Example: If your investment on an asset in May 2013 is $25,000  and you sold the same in July 2016 at the cost of Rs. $56,000, then your absolute returns in this case would be:

Absolute returns = ((56,000-25,000)/25,000)*100 = 124%.

This is the simplest method to calculate returns. But this does not consider the time period of the investment.

2. Simple Annualized Return

• It is the percentage increase or decrease an investment achieves for a year or more (specific period).

Simple Annualized Return = Absolute returns / time period

Example: You have made an investment for $2,00,000 which has become $2,50,000 over three years, then your simple annualized return would be:
Absolute return = ((2,50,000-2,00,000)/2,00,00)*100= 25%

Simple annualized return = 25 / 3 = 8.33%

3. Average Annual Return

• The arithmetic mean of a series of ‘ROI returns’ forms the ‘average annual return’ in percentage.

Average Annual Return = (Return in period 1 + Return in period 2 +.....+Return in Nth period) / Number of period (n)

Example: Let us assume you have investment records from 2016 – 2019 as follows:
Year       Annual return
2016               25%
2017               20%
2018               15%
2019               28%

Average Annual Return (2016-2019) = (25+20+15+28)/4 = 22%

This is used for determine the ROI but cannot be considered as common formula for analysis.

4. Compound Annual Growth Rate (CAGR)

• It is the growth rate of the investment year over year for a specified period of time. This helps determine the annual growth rate on an investment whose value has fluctuated from one time period to the next.

Compound Annual Growth Rate = ((End Value / Start Value)^(1/Periods)-1)

Example: Let us assume that your investment of 10,000 in May 2011 became $ 25,000 by May 2018 and by May 2019, it became $15,000; then your CAGR would be:

CAGR = ((15,000/10,000)^(1/2))-1= 22.47%

Investors usually compare the CAGR to evaluate how well ones’ stocks or mutual funds have performed against other stocks in peer group or against the market index.

There are many more detailed ways of calculating the ROI such as IRR, XIRR, rolling returns etc.