In the financial world, return on investment (ROI) refers to a set of calculations and theories that measure how profitable your investment is over time. While being comfortable with the metric is incredibly important, we’re going to cover a slightly different angle first: the return on investment for long-term strategies. (Don’t worry – we’ll get to those calculations, too).
Investing is not just a tool for the rich – it’s an essential component of how you become rich. While dumping your life savings into the stock market when you’re 50 can feel like a big win, you actually have the money to invest now! It’s actually long-term strategies that build not only a larger return on your investment, but steadier portfolios, as well. While not everyone who invests automatically becomes rich, almost everyone who invests for fifty years becomes richer than their peers who don’t.
One of the big reasons for this (other than tying up your funds where you can’t spend them) is that investment growth is one of a few ways to hedge against inflation. While there are losses to be had, there are also enormous gains – or at least stable gains. In fact, for many, investing is the only way retirement will be possible.
Q.ai Says: Rich or poor, return on investment is an essential forefront consideration for any investor – which is why it’s so important to start investing as early as possible.
First, let’s start with some examples of why investing early is essential for maximizing your earnings potential.
The point is that investing early and contributing regularly are the two best ways to ensure that you build a rich, robust portfolio of securities. Regardless of your final goal, every investor is throwing money toward the same hope: that their money will make more money. However, the younger you invest, the more money your money will make in the long run.
If you want to check this theory for yourself – or if you want to scrutinize the earnings potential of a nifty little stock you’ve got your eye on – you can do so with ROI calculations. The basic calculation is best for a quick examination of a stock, while the net investment calculation accounts for losses, gains, and trading costs.
However, the fullest picture comes out of the annualized return ROI calculation, which also looks at an investment’s potential for growth over a specified period of time.
While finagling with these equations may take a little practice, after a few tries, they’ll seem as natural as perusing investment opportunities with your morning coffee.
Investing Early is the Key to Success
The key to investing is just to do it. Whether you can afford $100 a month or $1,000, starting early and sticking with a regular investing schedule – even in poorly performing markets – will generate a far greater return on investment than intermittent (or not) investing.
Rather than expend a lot of language describing why this is true, we’re going to jump straight into some examples. For each of these examples, we’re going to assume that our investors:
- Invest an initial sum of $200 plus $200 per month
- Earn a modest 5% return rate on investments
- Pay no taxes until the funds are withdrawn
To begin, let’s name our three investors: Sue, Sally, and Steven.
Investor 1: Sue Smart
Sue Smart comes from a family who believes in investing in the stock market regardless of your current financial situation. As such, she invests $200 of her birthday money into the stock market on the day she turns 18 years old. She continues to invest like clockwork until she’s 65 – a total of 47 years.
As you can see from the chart below, over time, Sue invests nearly $113,000 of her own money into the market in her lifetime. By the time she’s ready to leave the workforce, she’s amassed almost $326,000 in interest on her return, bringing her portfolio value to $439,000. That’s a pretty tidy nest egg to kick off her retirement!
Investor 2: Sally Smalls
Next up, we’ll consider Sally Smalls, who comes from a family that doesn’t know much about the financial markets. She does a little research on her own as she gets older and finally takes the plunge on her 30th birthday. She invests an initial $200 in the market and, after seeing some promising returns, dutifully invests every month until she’s 65 years old.
As you can see from the chart below, over her 35 years of investing, Sally contributes about $84,000 of her own money into her portfolio. When she retires, she has earned just under $140,000 in interest, for a grand final value of $223,000. Simply by starting 12 years later, Sally Smalls’ portfolio is worth almost half of Sue’s by the time she retires!
Steven Stubborn comes from a background that does not put much stock in the financial markets. As such, he doesn’t start investing until his 45th birthday, when he sees how much money his friends Sue and Sally are making off their portfolios. Following their advice, he takes their gift of $200 and invests it into the market. After seeing some small returns and looking at the state of his retirement plan, he decides to invest faithfully until he retires at 65.
As you can see from the chart below, Steven invests about $48,000 of his own money into the market throughout his 20 years of investing. However, at the end of that time, he has only earned $34,000 in interest, for a final portfolio value of $82,000. While this is nothing to laugh at, it’s also a pittance compared to the gains seen by Sue and Sally, who started so much younger.
What’s the Bottom Line?
The younger you start investing, the more money you’ll have come retirement. This is due to a combination of factors, such as contributions over time and compounded interest over the years – the main generator of return on your investments.
Investing Early Without Continual Contributions
While investing throughout your life is an excellent way to build retirement assets, when you start investing is perhaps more important than how long you invest. Again, let’s jump right into our illustrations. For each of these examples, we’re going to assume the same scenario.
Each of our investors invests $200 into the stock market initially and continues contributing for a duration of 10 years, paying no taxes and withdrawing zero funds.
At the end of 10 years, our investors have all put $24,000 into the stock market and generated an average 5% rate of return. This increases their portfolio value to almost $33,000 in that time period ($24,000 of capital plus $8,600 in interest).
Let’s say that Sue Smart invests $200 per month from ages 18 to 28, and then stops due to financial difficulties. After a while, she all but forgets about her money sitting in the market – but the market doesn’t. The money sits there until she turns 65 and decides to retire and take a peek at her portfolio.
Over the past 37 years, Sue’s money has grown from $33,000 to over $200,000 – an impressive, but still modest, $167,500 in interest at 5% returns.
Sally Smalls, on the other hand, hasn’t learned from her previous example. She firsts invests at age 30, and then decides on her 40th birthday that she’s had enough of throwing her money into the stock market. She leaves her accounts to grow without additional contributions, but doesn’t cash in on her profits yet, either.
Because Sally started investing ten years later in her life, that means she has ten fewer years to generate interest on her investments. Therefore, instead of amassing $167,500 in interest, she’s only earns $78,000 by the time she hits 65. When she retires, she only has $111,800 in her portfolio – once more, about half as much as Sue Smart.
Steven Stubborn, that stickler, didn’t learn much from his previous example, either. He doesn’t invest until he’s 40 years old. By the time he’s 50, he decides to start his own business and throws all of his money into his new endeavor. However, he did pay some attention in his last example, as he leaves his investment account alone to accumulate interest.
As a result, when Steven cashes in his retirement account at 65 years old, he’s barely doubled his money to $68,600. Because he started so late and stopped when he was 50, his money only had another 15 years to grow before he needed it. Steven! (Smh).
The Bottom Line
The earlier you invest – and therefore the longer you invest – the larger your returns will be. As your money earns interest, assuming you leave your earnings in the stock market, you will have a larger principal to invest at the start of every year. Pretty soon, the amount you earn in interest will eclipse your contributions over time – that’s when your interest really starts to earn its own interest, which earns even more interest…
You get the idea. The earlier you invest, the richer you’ll be.
We should also note that for the sake of brevity and simplicity, these examples assume that contributions remained stable over a set period of time. They also assume a consistent annual return. The only number that continually increased was the starting amount, which went up every year as a result of the compound interest. However, how much you contribute independently also make a big difference in your potential earnings.
While we simplified our examples for illustrative purposes, many financial experts suggest saving (and investing) a total 15% of your salary for retirement. As your salary goes, so will your contributions – assuming you stick to a percentage model.
Qai Says: As a rule, investors should diversify investments across retirement accounts, stocks, and bonds, depending on their risk tolerance and financial situation.
Calculating Your ROI
We promised we’d come back to these calculations, didn’t we?
As we mentioned earlier, ROI (return on investment) is a financial metric, typically expressed as a percentage, that measures the likelihood a certain investment will produce financial returns over time. To do so, the ratio compares losses or gains on an investment against the cost of purchase. ROIs are useful for evaluating standalone investments and portfolios alike – in fact, the first portion of our article hinged on a version of the annualized ROI calculation (more on that below).
Business analysts use cash flow measures such as ROI, IRR (internal rate of return) and NPV (net present value) to give a complete picture of a particular security’s financial state. Much like a doctor runs blood tests and uses the data to determine how healthy their patient is, these metrics are essential in understanding the health, history, and future of a particular investment or business.
Essential ROI Formulas
There are two basic formulas for ROI, with each serving a slightly different analytical purpose. The first calculation merely shows your ROI in regard to the purchase and sell prices of the investment, which can provide a first glance at a particular security.
The second formula takes a more thorough approach to calculating the costs and gains of your investment(s).
Let’s examine both.
Formula 1: Measuring the Investment at Face Value
The first formula is the easiest to calculate, as it has the fewest variables to consider:
Let’s give an example of this first equation. Say you purchase 100 shares of Awesome, Inc’s stock at $25, and sell them six months later for $75 apiece. Your calculation would look like this:
Not too shabby for a first investment!
Unfortunately, however, calculations will rarely be this simple, as there are several other factors to consider when calculating ROI. (Not to mention you’ll rarely see such a high return on investment in a year!) This is where the second calculation comes into play.
Formula 2: Measuring the True Cost of Your Investment
This formula is a little more complex than the first, but it provides a more comprehensive view of your financial picture by accounting for more variables:
Qai Says: When calculating your net return, be sure to consider factors such as commissions versus split commissions, capital gains, and dividends in addition to gains or losses on the investment themselves. This will give you a more comprehensive picture of how well your investment performs.
Let’s give an example of this second equation. Say that you purchase 100 shares of Awesome, Inc’s stock at $25, and sell them a year later at $35. Let’s also say that your broker charged you $100 in commission on the trade, and during the twelve-month holding period, you earned $200 in dividends on your investment.
In this scenario, your equation would look like this:
Let’s break this calculation apart further.
Numerator. Here, we consider three factors:
- The buy and sell cost of your investment (($35 sell price – $25 buy price) x 100 shares)
- The dividends you earned +$200
- The commission you paid -$100
Denominator. The bottom number is simpler. Simply multiply the cost per share by the number of shares purchased.
Qai Says: To make the equations simpler, you can always calculate individual components of the equation before plugging them in. By inserting the answers to the equations in the bullet points above, you would get:
While these calculations provide a decent overview of an investment’s potential, they don’t account for how long an investor holds a security. This knowledge is incredibly useful to have to compare investments against each other over time.
Therefore, investors who want the most complete picture of their ROI potential often turn to the annualized calculation (which is what we used in our examples above). This calculation considers the effects of compounding, which makes a big difference when you hold an investment for several years to multiple decades.
Annualized ROI Calculation
The formula for annualized ROI looks a little complex, but once you have the hang of it, it’s a piece of cake. The equation looks like this:
· In this equation, “n” is equal to the holding period, which is measured in years. To calculate investments held for a period of months, you would use a decimal. For instance, 6 months = 0.5, and so on.
· ROI refers to the numbers from the first calculation before they’re converted to a percentage
Let’s give an example using this equation. Say that you calculate your basic ROI to be 25% over a period of five years. Instead of calculating your annual ROI by averaging your returns (25% / 5 years), you can get a more accurate view of your ROI through the annualized equation.
Thus, you would plug the data into the equation above to get:
And it’s that simple!