What is ROI?
Return on Investment (ROI) is a performance measure used to evaluate the efficiency or profitability of an investment. It measures the amount of return on a particular investment, relative to the investment's cost.
The Formula
Annualized ROI
If you hold an investment for multiple years, the simple ROI doesn't tell the whole story. The Annualized ROI calculates the geometric average amount of money earned each year.
A Worked Example
You invest $8,000 in stocks and sell three years later for $11,200. Your net profit is $11,200 − $8,000 = $3,200, so your total ROI is ($3,200 / $8,000) × 100 = 40%. But that 40% is spread across three years. Annualizing it gives (1.40)^(1/3) − 1 ≈ 11.9% per year — a far more useful number when comparing against, say, a savings account paying 4% annually.
Why Percentages Beat Raw Dollar Amounts
A $10,000 profit sounds impressive — until you learn it took a $1,000,000 investment to earn it (a 1% ROI), versus a $2,000 profit on a $5,000 investment (a 40% ROI). ROI strips away the dollar amounts and lets you compare wildly different investments on equal footing.
Common Mistakes to Avoid
- Forgetting fees and costs: Subtract all transaction fees and holding costs from the final value before calculating profit, or you'll overstate your return.
- Comparing across different time periods: A 50% ROI over 10 years is far worse than a 20% ROI in a single year. Always annualize before comparing.
- Ignoring inflation: A 5% ROI during 6% inflation is actually a real loss of purchasing power.