Learn the simple return on investment formula and know what to expect with average return numbers for different asset classes, including stocks, bonds, and real estate.
Before we dive right in to the return on investment formula, you should know why it’s important and how investors use it to make decisions. Basically, return on investment (or ROI) tells you how much money you have made. This is called your return.
The return on investment formula itself is important because it is a ratio, or a percentage, and because of this we can use it to compare investments.
For example, pretend we wanted to compare an investment Warren Buffett made with one that Joe Schmo made. Because Buffett has access to billions of dollars, his result could look better than reality just because he started out with a ton of money.
If Buffett bought $5 million worth of stock in a company but ended up with only $1 million, obviously he didn’t make a good investment. Whereas if Schmo turned a $100,000 investment into $150,000, he did really well. A ratio like return on investment shows us that Schmo’s return of 50% was better than Buffett’s return of -80%, even though Buffett had more money at the end.
ROI is also important because it can help investors make important decisions. Obviously everybody has different financial goals. When you know what kind of returns to expect, you can make smart allocation decisions, like what percentage of income to invest with and in which asset classes.
Especially in the investment industry, ROI is used as a measuring stick and a way to evaluate performance from fund managers and other financial professionals. One thing you should consider is that a high ROI is usually correlated with higher risk. Bear that in mind.
The Return on Investment Formula
Now on to the formula. To calculate ROI, use this formula:
[(Current Value – Value at Cost) / (Value at Cost)] x 100
You should apply the return on investment formula on any investing you do.
If you bought some stocks, as an example, then the price you bought the stocks at is your “value at cost”. The current value would be the price the stock is at now, or the price you sold the stock at. Another way to look at the return on investment formula is like this:
[(Net Profit) / (Investment)] x 100
Keep in mind that you won’t always make a profit on your investments, and so the net profit could actually be a net loss. You can apply ROI on past transactions, or you can apply ROI to calculate current return as a hypothetical (i.e. if you were to sell today).
For further clarification on this calculation, here’s a nice short video explaining how to calculate ROI.
The question inevitably becomes, “what’s a good ROI?”
This is a loaded question. For one, what one might consider a good ROI on a stock isn’t necessarily a good ROI long term, and vice versa. Since I’ve had some experience managing a stock portfolio, I can tell you that ROI on individual positions can vary widely.
For example, some of my positions have seen as high as 50% gains or higher. Yet you have to understand that it takes a whole portfolio of out-performance to really bring your total ROI up. For every stock with a really low ROI, it’s going to take another stock with really great ROI to counterbalance it. So it’s really about limiting losers than it is finding winners.
Long Term Stock Market Returns
Another thing about the stock market is that returns often take a long time to develop. You don’t want to be one of those people who are checking their ROI daily. Not only is that a recipe for disaster, as it will drive you crazy, it’s also extremely time consuming and counterproductive.
That said, common wisdom states that the stock market has returned on average 7% a year over the last century. That number is going to change depending on the year you calculate it, and some have even gone so far to say you can expect 10%, but it’s usually closer to the 7% number.
Also you should know that inflation averages around 2 – 3% a year. When factoring this number with GDP growth, and add a percent or 2 for dividends, then this is how you get the average of 6-7% a year for the stock market.
This tells us that anything over 7% a year is excellent. The fact that Warren Buffett averaged over 20% a year is even more astonishing with this knowledge.
Now let’s look at some asset classes and their average return on investments (ROI).
Notice that we want the geometric average of an asset’s returns, and not the arithmetic average. The reason for this being that in a scenario where we have returns of 100% and -50%, our arithmetic average is 25%, which is incorrect. Our real average in the situation is 0%, which the geometric average also confirms.
From FRED data and academic research, the historical returns for stocks, treasury bonds, and treasury bills are the following:
Stocks (S&P 500): 9.55%
Treasury Bonds: 4.93%
Treasury Bills: 3.53%
This average was calculated over an 85 year period, and the averages change depending on which period you choose.
Read that last line again, because it is so important. “The averages change depending on which period you choose.”
The problem with finding averages in ROI is that they always change. The average return on the time period (2000-2008), when the stock market had just crashed and a chaotic bear market was on the loose, will be much lower than the average return on a time period (2008-2014) with a raging bull.
This is why average return on investment calculations are extended to include as long of a time period as possible. A calculation with many bear and bull markets involved is much more credible and useful. However, it’s still subject to bias depending on which year is selected for the beginning and the end.
Here’s another comparison of asset class average returns from the last 30 years that I found intriguing (1983-2013):
International Stocks: 9.84%
Small Cap Stocks: 9.81%
Municipal Bonds: 7.12%
Long term Gov’t Bonds: 9.44%
Corporate Bonds: 8.46%
Single Family Real Estate: 4.38%
It’s generally accepted that bonds will lag stocks in terms of ROI. However, they are also seen as less risky and less volatile.
In the end, your investing decisions will ultimately be up to you.
No matter where you go, average ROI numbers will be flashed and used as a defense for this strategy or that. Use this information I’ve given you today to smirk at these attempts. Realize just how fluid average return numbers are, and learn to research and think for yourself.
With this blog post, you will be better equipped to plan for your financial future and make difficult financial decisions. Regardless of your decisions, always choose knowledge.
**All Rights Reserved. Investing for Beginners 2014**
**Return on Investment Formula (ROI) & Ex. Average Returns**