One of the most popular ways to measure an investor's prowess is to calculate their return on investment, or ROI. In the most basic sense, ROI measures how efficiently an investment generates profits -- that is, how much it returns for every dollar invested.
ROI is expressed as a percentage of the original investment, and it's simple to calculate:
(current value-original investment) / original investment x 100%
Let's say you just sold your house for $300,000 (current value). Twenty years ago, you bought it for $100,000 (original investment). Therefore, your ROI is 200%:
($300,000-$100,000) / $100,000 x 100% = 200%
That's a pretty impressive ROI. For every $1 you invested in your home, you got $3 in return.
You can use ROI to make better decisions in many areas of your life. It can help you to:
- Decide where to invest your money.
- Determine how to approach paying off debt.
- Recognize the importance of a financial safety net.
- Decide when to buy or sell individual stocks.
- See what's really important to you in life.
Image source: Getty Images.
The three big limitations of ROI
But ROI has its limitations, too. First and foremost, it doesn't take time into consideration. Let's say I invested that same $100,000 in shares of Amazon instead of a house. Two years later, it's worth $150,000 -- an ROI of 50%.
If we compare the Amazon investment to the house, the house appears to have the much better return -- 200% versus 50%. But it took 20 years to achieve that 200% ROI, while the Amazon investment's ROI of 50% took just two years to accomplish. Indeed, if we measure the compound annual growth rate (CAGR) of each, it's clear that Amazon is a far better investment: It has a CAGR of 22.5% per year versus the house's 5.6% per year.
The second limitation of ROI is that it doesn't take risk into account. Over the long run, stocks tend to be the most profitable investment the ordinary investor can make. But over the short term, they can be extremely volatile. Imagine investing $10,000 in stocks in 2007, just in time to watch almost half of it wiped out in the Great Recession. If you were forced to sell those investments because you also lost your job during this period, your ROI would have been nowhere near the market's because you were forced to sell low.
Finally, ROI only measures financial returns. It cannot measure some of the softer variables that make a big difference in our lives, like our stress levels, connection to family and friends, health, and general happiness. If we use ROI as our North Star in decision-making, it can lead us to neglect all of these important parts of our life.
Below, we'll cover five different ways to use ROI while taking these limitations into consideration.
1) Deciding where to invest your money
Let's do a little thought experiment: Out of nowhere, you come into an extra $10,000. All of your high-interest debt (more on that below) has been paid off, and you need to decide what to do with the money. Your options are to invest it -- say, in stocks, bonds, or real estate -- or to keep it in cash.
Wherever you put the money, you have to keep it there for a minimum of 10 years. What's the best choice based on the potential ROI of each investment? The answers are pretty clear. Consider that between 1928 and 2017, after inflation:
- Stocks have had a CAGR of 6.7% per year.
- 10-year government bonds have had a CAGR of 1.8% per year.
- Real estate has had a CAGR of 0.9% per year.
- Cash, due to inflation, has lost value, with a CAGR of -2.9% per year.
If we try to calculate the ROI over 10 years, the best choice among these options becomes crystal-clear: stocks.
Chart by author. Author's calculations.
Think of it this way: After 30-years, your $10,000 investment in stocks would be worth $70,000 in today's dollars, assuming stocks returns moving forward match their historical averages. The estimated value of that same investment in bonds ($17,100), real-estate ($13,100), and cash ($4,100) would pale in comparison.
2) Deciding how to pay down debt
That doesn't mean that you should run out and invest every spare penny into stocks. That's because we Americans have a boatload of debt -- whether it's in the form of a mortgage, student loans, auto loans, or -- worst of all -- high-interest credit card debt.
Currently, the average credit card charges an interest rate of roughly 16%. That's a very high rate, and even if we account for 3% inflation, the ROI that credit card companies are making off their customers (13% per year) is higher than what you're likely to earn through any investment -- even stocks. That's why paying off your high-interest debt is more important than investing.
Let's put it this way. You have $10,000 in credit card debt when you magically come into your $10,000 windfall. If you were to invest that money in stocks and earn an inflation-adjusted 6.7% per year for the next 10 years, then you'd have $19,100.
Meanwhile, however, your credit card debt would continue growing unabated. That $10,000 IOU to the credit card company would balloon to $33,900. Even after your impressive stock returns, you'd be $14,800 deeper in the hole than if you had simply paid off the debt in full.
This isn't a perfect example, because your credit card company would have demanded minimum payments along the way, but it spells out the dynamics at play with ROI and debt. You don't actually make money by paying off debt. But if you view "money saved" as "money earned," then the ROI is excellent.
Technically speaking, you're better off paying back lower-interest loans -- like your mortgage or car -- over the long run and investing the difference. In practice, this means paying back the lower-interest loans on the agreed-upon schedule with monthly minimums. In other words, if your mortgage rate is 4% and your expected stock return is 10% (before inflation), then your spare cash is better off going toward stocks than anything beyond the minimum mortgage payment.
If you have the discipline and fortitude to put that extra cash in stocks -- many will either spend the extra money or be afraid to invest it -- then more power to you. Otherwise, some argue that the psychological freedom that comes with paying off all of your debt beats the ROI you might earn on stocks.
3) Recognizing the importance of a safety net
Here's where things get really tricky. Almost every financial planner worth his/her fees will tell you to build up an emergency fund that can provide three to six months' worth of living expenses in case you incur a major expense or lose your income stream.
But in terms of ROI, this seems like a terrible investment. Remember, cash has historically generated negative 2.9% per year, so an emergency fund is literally a money-losing venture. However, if we take a step back and look at the purpose of an emergency fund from a wider perspective, we can see that they are a vital insurance policy that helps us achieve market-matching returns in stocks over the long-run.
Best-selling author, trader, and NYU professor Nassim Nicholas Taleb has long preached that for most people, your returns will not match the markets. In an interview earlier this year, here's how he explained it:
The market may deliver whatever people claim it will deliver. But if you have a drop in the market that may force you to liquidate -- particularly a drop in the market that may correlate with your loss of business elsewhere -- then, automatically, your returns will be the returns from today until that drop in the market. It de-correlates from the market.
As an example, many investors who didn't have emergency funds in 2008 got a terrible ROI on their stock investments. They needed money because they lost their jobs, as many people did during the Great Recession, and they had to sell stocks at the worst possible time: a multiyear low in the market.
And it doesn't necessarily even have to be a recession we're talking about. Any unforeseen personal chaos puts you in danger: a sudden divorce, a medical emergency, or another major life change that requires you to free up cash. If you don't have that emergency fund on hand -- despite the terrible ROI that it gets -- you don't have the insurance policy necessary to help your investments keep compounding without interruption. Not only that, but the emergency fund can keep you from making emergency purchases on your credit card -- which we've already established as a terrible ROI.
4) Making individual stock choices
Of course, you can also use ROI to help you make decisions regarding individual stocks as well. More often than not, financial websites will refer to ROI as ROIC, adding "capital" at the end. For our purposes, the two are largely synonymous.
Like all stock metrics, ROIC has its own set of limitations. Most notably, ROIC is only an important data point when you're comparing two companies in similar industries. It wouldn't make much sense, for instance, to compare the ROIC of Amazon (9%) to that of Domino's Pizza (80%). Amazon is busy reinvesting its sales into growth opportunities that may take years to show profitability. Meanwhile, because Domino's business has improved dramatically in recent years, it is able to build new stores and quickly turn a profit on that investment. But that doesn't necessarily make Domino's a better investment than Amazon.
However, if we were comparing Domino's to Papa Johns, it would make perfect sense to consult ROIC. Papa Johns earns far less on its invested capital (26%) than Domino's -- which might help to explain why Domino's has vastly outperformed its peer over the past 10 years with returns of almost 2,000% versus Papa John's 260%.
5) Remembering your own North Star
For all of the numbers being thrown about, however, you must remember the most important shortfall of ROI: It only measures money. And when it comes to investing, remember that it should serve a greater purpose than making money just for money's sake. It may help you buy a house to enjoy with your family, retire in comfort, or free up your time, for example. No matter your goal as an investor, it should be something that adds lasting value to your experience of life.
A recent story from the blog Intelligent Fanatics titled "Life is More Than Compounding Money" drives the point home. It tells the story of Anne Scheiber, a woman of modest means who died and -- to the surprise of everyone but her attorney -- left $22 million to Yeshiva University in 1995.
Most claimed this was a textbook example of how nearly anyone can succeed at investing given the appropriate approach. With Scheiber, however, that approach came at a cost:
She didn't have a family, nor did she try to form meaningful relationships with those around her. This stemmed from a deep distrust of others. Her attorney Benjamin Clark and financial broker William Fay were her only acquaintances.
Virtually all of her time was spent following the stock market. We can't confuse the destination with the journey necessary to get there. Scheiber deprived herself from what makes life worth living.
There's no doubt Scheiber had an incredible ROI. That's not the point.
Let's keep things in perspective when using this metric. It can help you allocate your money so that you can focus on the important things in life. Making sure you have those "important things" is the overlooked first step. After that, ROI can help you get to where you want to go.
