Return on Investment

Return on Investment (ROI) is a measure that helps determine the profitability of an investment. It compares the cost of an investment to the earnings it generates, allowing for an evaluation of its efficiency. Both individual investors and businesses utilize ROI to assess their investments. Here's a clear explanation of what ROI entails, how to calculate it, and the benefits of doing so:

What Is ROI?
ROI provides insights into the profit or loss generated by an investment or business endeavor. It is a simple ratio that divides the net profit (or loss) by the cost of the investment. Expressed as a percentage, ROI enables the comparison of different investment choices and their effectiveness or profitability. It is closely related to metrics like return on assets (ROA) and return on equity (ROE).

How to Calculate ROI
To calculate ROI, divide the amount earned from an investment (net profit) by the cost of the investment, and multiply the result by 100 to express it as a percentage. There are two ways to represent the formula:

ROI = (Net Profit / Cost of Investment) x 100

ROI = ((Present Value - Cost of Investment) / Cost of Investment) x 100

For example, if you invested $5,000 in company XYZ and sold your shares for $5,500, the ROI calculation would be as follows:

ROI = ($5,500 - $5,000) / $5,000 x 100

Your ROI for the investment in company XYZ would be 10%. Remember to factor in taxes and fees for a more accurate calculation.

How to Use ROI
ROI can be used by regular investors to evaluate portfolios or applied to assess various expenditures. For business owners, ROI helps calculate the return on advertising costs or evaluate different renovation options. However, it's important to note that ROI is reliant on the accuracy of the input data and does not eliminate risk or uncertainty. Investors must consider the potential for optimistic or pessimistic projections and understand that historical performance does not guarantee future success.

What Is a Good ROI?
While an annual ROI of approximately 7% or higher is often considered good for stock investments, determining the appropriate ROI depends on individual factors such as risk tolerance and investment goals. It's essential to carefully consider these factors rather than relying solely on a benchmark. Evaluating personal risk capacity, potential loss, required profit, and alternative investment opportunities can help determine the suitable ROI for an investment strategy.

Limitations of ROI
ROI has certain limitations to consider. It does not account for the element of time, which means it may not accurately compare investments held for different durations. Annualized ROI can address this limitation by considering compounding returns over time. Additionally, accurate ROI calculations should include all costs associated with the investment, such as transaction costs and taxes. Furthermore, ROI calculations that solely rely on estimated future values without assessing risk can be misleading, highlighting the importance of cautious decision-making.

By understanding ROI, calculating it accurately, and considering its limitations, investors and businesses can make informed decisions, assess profitability, and effectively manage their financial endeavors.

For a ‘deeper dive’ into understanding ROI in the context of an investment, consider the following:

When we discuss "return" in the context of an investment, it refers to the increase in value or wealth generated by that investment. It is commonly expressed as a percentage of the initial amount invested. However, the investment landscape is filled with various terms and terminology that can be overwhelming. It is crucial to monitor and evaluate your investment portfolio, as well as assess potential new investments, as part of your overall investment strategy.

Understanding the concept of "return" and its different forms is central to this process. Let's guide you through the fundamentals of calculated and reported returns that you are likely to encounter in your investing activities. While these concepts apply to any investment asset (stocks, bonds, real estate), we will focus on equity and mutual fund examples for simplicity.

01 | Price Return
This is the most basic type of return you will come across. It represents the change in the market price of an asset, such as a stock, bond, or mutual fund unit, considering only the capital appreciation. It does not take into account any income generated, such as interest or dividends, and does not adjust for factors like inflation, taxation, or risk. Price returns are often associated with widely referenced indices like the S&P 500 Composite and the S&P/TSX Composite, especially for shorter time intervals like days or weeks. However, since most assets, including stock portfolios represented by an index, generate cash flows such as dividends, relying solely on price return can provide a misleading representation of an investment's return.

02 | Total Return
Total return expands upon the basic price return by capturing all cash flows associated with an investment over a given period. For benchmark indices or individual stocks, this includes the change in market price (as illustrated in Example 1) as well as all dividends, interest payments, or other distributions during the same period. When calculating total return, it is typically assumed that all cash distributions were reinvested in additional units (e.g., shares) of the underlying asset at the time of distribution. When comparing your investment returns to indices, benchmarks, or alternative investments, it is important to compare total returns rather than relying on tools or calculators that only consider price returns. Most popular indices, like the S&P/TSX Composite, publish total return versions. Returns provided for funds and benchmark indices in all official materials from IG Wealth Management will always be total returns.

03 | Real Return
The return measures we have discussed so far are considered "nominal" as they only reflect the stated changes in dollar values. They do not account for changes in the value or purchasing power of those dollars. Real returns, on the other hand, adjust for the impact of inflation. In periods of low inflation, the distinction may not be significant, but during times of high inflation, expressing returns in real values provides a clearer understanding of how an investment contributes to wealth growth. Additionally, even low inflation rates can accumulate over time, leading to significant differences in end values. Thus, returns measured over longer time frames, such as five years or more, are best viewed in real terms. To calculate real returns, one commonly adjusts measurements to maintain the constant purchasing power of a given capital level (e.g., $100.00) over time, often using a broad price index like the CPI (Consumer Price Index).
A simple rule of thumb involves subtracting the annual inflation rate from the nominal annual rate of return (e.g., +14.07% return - 2% inflation = +12.07% real return). More precisely, the formula for real return is: Real Return = [(1 + nominal rate) ÷ (1 + inflation rate)] - 1.

Understanding these different forms of return and their implications can help you make more informed investment decisions and assess the true performance of your investments in relation to inflation and other factors.

04 | Relative Return
Relative return typically denotes the return generated by an investment or portfolio in comparison to a specified benchmark or index. For example, if a hypothetical large-cap diversified Canadian equity portfolio achieves an absolute return of 10%, while its benchmark, the S&P/TSX Composite Index, attains a return of 6%, the relative return would be 4%. This indicates that the portfolio outperformed the benchmark by 4%.

05 | Risk-Adjusted Return
A fundamental principle of investing is that investors should be appropriately rewarded for the level of risk they undertake over a reasonable period of time. When considering the acceptance of higher risk for a given expected return, a rational investor would demand a lower purchase price. In other words, investors should be compensated for assuming greater risk by being offered a higher expected return. Therefore, it is crucial to incorporate a measure of risk when evaluating investment performance.

Risk-adjusted returns aim to refine or adjust a measure of an investment's return to account for the level of risk involved in generating that return. If multiple investments deliver the same rate of return over the same timeframe, the one with the lower risk measure is considered to have a better risk-adjusted return. Risk can be understood in various ways, but in investing, it is typically assessed based on the volatility or variability of results. Standard deviation, a statistical measure that gauges the dispersion of realized returns from the mean, is commonly used to quantify variability. A higher standard deviation indicates greater dispersion of data points relative to their mean, reflecting higher risk.

Securities with higher perceived fundamental risk factors, such as poor market liquidity or high financial leverage, tend to exhibit higher standard deviations. The most widely used risk measure for comparing mutual funds is the "Sharpe ratio." It quantifies the excess return of a fund above the risk-free rate per unit of standard deviation. The underlying assumption is that investors always have the option of a risk-free investment, typically represented by the Government Treasury Bill rate of return for the given period. Therefore, any assessment of investment returns should include consideration of the return available in the risk-free space.