ROI is a financial metric typically expressed as a percentage or ratio that measures the profitability of your investment(s) over time.
- You can calculate several types of ROI to account for factors such as commissions paid, dividends earned, and the effects of compound interest
- To calculate your basic ROI, subtract your initial investment value from the final investment value, divide by the cost of your investment, and multiple the result by 100%. Voila!
- Historically speaking, the earlier you invest, the better returns you’ll see – for instance, the modern S&P 500 has returned almost 1000% since 1957, while the Nasdaq Composite has returned almost 14,000% since 1971!
Investing is often thought of a tool for the rich, a way for the already-wealthy to put their money to work while they enjoy the luxuries of the upper echelons. But in fact, for those who aren’t rich already, investing is an essential component of how you become wealthy (or at least wealthier).
Not everyone who invests automatically becomes rich, of course. But almost everyone who invests for fifty years becomes richer than those who don’t.
One of the biggest reasons for this is that investment growth is one of the best ways to consistently hedge against inflation. Another is that, despite occasional economic downturns, the market has historically always performed – eventually. And while it’s possible to lose big, it’s also possible to net enormous gains.
At the end of the day, these gains – your ROI – are the biggest argument for why you should invest (and invest early, if at all possible).
What is ROI?
Your ROI, or return on investment, is a financial metric – typically expressed as a percentage – that measures the potential and actual profitability of your investment(s) over time. A working familiarity with ROI is important for self-directed investors especially, as ROI can help inform investing decisions and shed light on which investments under- or overperformed.
We’ll cover a few examples of ROI that demonstrate the importance of investing early in a minute. But first, let’s take a look at the base calculations.
Calculating Your ROI
The function of ROI is to produce a ratio that represents the percentage loss or gain of your investment. You can calculate several types of ROI – but for our purposes, we’re just going to look at the basic formula:
Let’s break this down a bit. Say that you purchase 100 shares of iLuvDogs stock at $1.50 apiece for a total investment of $150. Then, you sell your position one year later at $5 apiece, or $500 upfront. To calculate your ROI, you would plug your variables into the above formula like so:
Or to simplify the equation:
Of course, your calculations will rarely be this simple. More complex ROI formulas can include factors like investing costs (commissions, brokerages fees, etc.), taxes, earned dividends, the effects of compounding, etc. The base outline for these equations looks like this:
In this equation, you add or subtract any relevant returns or costs on the top line to figure your net return, depending on which type of ROI you want to calculate.
So, Why Invest?
Now that we’ve covered the basic ROI calculation, let’s apply the calculations to a few real-life examples that show the value of investing over time. To do so, we’ll examine the simple (non-annualized) total return on investment of the three major stock indices – the S&P 500, Nasdaq Composite, and Dow Jones Industrial Average – from their inception until market close on 21 June 2021.
Of course, these equations have their limitations. They don’t account for how much an individual investor would have made after commissions, taxes, the eroding effects of inflation, or how much an investor could have put in or taken out in that period of time. And since we aren’t calculating year by year, these results don’t reflect periods of high losses compared to high returns.
The S&P 500, or Standard & Poor’s 500 Index, is a market capitalization-weighted index that tracks 500 of the largest U.S.-based publicly traded companies. The modern version of the index, which opened on 1 January 1957, is widely regarded as a benchmark for gauging the performance of large-cap U.S. equities.
- 1 January 1957 opening value: 386.36
- 21 June 2021 closing value: 4224.78
The Nasdaq Composite is a market-cap weighted index that includes over 2,500 common equities listed on the tech-heavy NASDAQ exchange. The index first launched in 1971.
- 1971 opening value: 100
- 21 June 2021 closing value: 14,030.376
Dow Jones Industrial Average
The DJIA, or Dow 30, is a stock market index that tracks 30 large, publicly owned blue-chip companies trading on the New York Stock Exchange and NASDAQ. The index opened in 1896 and was designed as a proxy to measure the health of the broader U.S. economy.
- 26 May 1896 published opening value: 40.94
- 21 June 2021 closing value: 33876.31
Why Invest: The ROI of Investing Earlier (Rather than Later)
We’ve seen in our real-life examples that, in the long-term, the market (or at least these indices) have historically always returned gains. But measuring success based on an index packed with hundreds of stocks is not the same as diversifying a regular portfolio with a robo-advisor. So, for practical purposes, is it still worth investing – let alone investing early, when so many are looking to get a head start in life?
The answer is still yes.
While there are no guarantees of returns in investing, of course, a few hypothetical examples can show the effects of investing (and investing early) in the life of our volunteer, Fiscal Fran, at different points between now and her retirement.
For these calculations, we’re going to lay down a few ground rules. Our investor:
- Always invests an initial sum of $250 on her birthday (January 1) plus $100 at the beginning of each month going forward
- Earns 7% return on her investments compounded annually
- Pays no taxes until she withdraws funds at age 65
Let’s get started.
Example 1: Fiscal Fran’s 18th Birthday Bash
In our first example, Fiscal Fran gets $250 for her 18th birthday and puts it to work in the stock market right away. After that, she continues to invest $100 on the first day of every month like clockwork until her 65th birthday.
As you can see from the chart below, Fiscal Fran invests a total of $56,400 in her own money over time – and earns over $359,000 in returns alone (measured as “interest” on the graph below) over 47 years. By the time she’s ready to retire, she has almost $416,000 saved up to take a well-earned vacation and tide her over until she passes on.
Example 2: Fiscal Fran Two’s 34th Celebration
In an alternate universe, Fiscal Fran’s alter-ego, Fiscal Fran Two, isn’t so lucky. Despite her best efforts, life gets in the way, and she doesn’t start investing until she receives a birthday check the day that she turns 34. This time, she’s determined to invest in her future – and so she does.
Unfortunately, Fiscal Fran Two lost 16 years’ worth of interest and contributions compared to the original Fiscal Fran. Over a period of 31 years, Fiscal Fran Two manages to squirrel away $37,200 in her investment account – but her earned returns drop to less than $92,000 by comparison. By the time she retires, she only has $129,000 in her brokerage account to kick off her retirement party.
Example 3: Fiscal Fran Three’s 50th
Fiscal Fran Three is the unluckiest of Fran’s alter-egos, as she comes from a background that doesn’t put much stock in the financial markets. As such, she doesn’t start investing until her 50th birthday – and after seeing unrealized capital gains accumulate in the first month, decides that this investing thing can’t be so bad, after all. So, she diligently tucks away $100 per month until she retires.
Unfortunately, that lost time really cost Fiscal Fran Three. In a span of 15 years, she contributes just $18,000 to her brokerage account, which earns a total of $13,700 in capital gains and dividend returns over a decade and a half. By the time she retires, she has just under $32,000 to fall back on.
The Real Value of Investing: Time for Your Funds to Grow
As we can see in our examples, barring a permanent and catastrophic shutdown of the global economy and financial markets as we know them, investing as much and as early as possible will generate larger returns than investing later (or not at all). And as you invest and your money earns interest, you can compound your earnings by reinvesting your profits right back into your portfolio – putting some truth to the phrase “earning stacks on stacks on stacks.”
So, how much should you invest in a non-hypothetical example?
Typically, financial advisors recommend stashing away at least 15% of your before-tax income in a combination of savings and retirement accounts if you start in your 20s. And as your salary increases, your contributions will rise, too – assuming that you stick to a percentage-based model.
However, the later you start investing, the more catch-up funds you’ll have to contribute to make the most of your retirement.
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