From the day that you finally start making money, people all around you start advising to “start investing.” It is true that saving and investing money is ingrained in our psyche and we are continuously looking for good investment options. But sometimes, choosing a good investment option can get confusing. How do you decide where to invest your money? Should you listen to a friend’s advice or go by your gut feeling? Well, actually neither. The best way to judge whether an investment is profitable is by looking at its Return on Investment or ROI.
What Is Return on Investment?
Return on Investment or ROI is a calculation that tells you the percentage of returns on any given investment. ROI is a very popular performance measure and is used by investors to choose the best investment option. ROI can be calculated by dividing the return or benefit on any investment by the cost of investment. In terms of the formula:
ROI = (Current Investment Value- Investment Cost / Investment Cost) *100
Let us understand this through an example:
If you invest INR 2,000 in buying shares of company X, and after a year the share prices go up resulting in an increase of your investments to INR 2500, then your return on investment would be:
ROI = (2500-2000)/2000 *100 = 25%
Thus, the ROI on investing in shares of company X is 25%. Assuming that you also invested INR 2,000 in company Y at the same time and now the investment stands at INR 2,200 your ROI will be:
ROI = (2200-2000)/2000*100 = 10%
With the help of ROI, you can easily compare and see that investment in the stocks of company X is a better investment decision.
In both the above cases, the time period for the calculation of ROI was taken as 1 year. But what if one investment gives annual returns while the other calculates returns every 3 years? How would you compare the ROI for both the financial investments?
For example, investment in Mutual Funds A gives an annual return of 30% while Mutual Funds B provides a return of 70% after 3 years. On the face of it, Mutual Fund B seems like a better investment choice, but if we consider the time periods, the picture changes. Let us see how:
- ROI for Mutual Fund A (annual) = 30%
- ROI for Mutual Fund B (After 3 years) = 70%
- ROI for Mutual Fund B (After 1 year) = 70%/ 3 = 23%
When we include the time horizons, it is clear that Mutual Fund option A gives a better ROI than Mutual Fund option B.
Why Is It Important to Consider the Cost of Investment for ROI?
The calculation of ROI gives due importance to the cost of investment as it gives a better and clearer picture of the returns. Hypothetically saying, you make a profit of INR 30,000 on your investment with Fund A while Fund B only provides INR 5,000. So, which one is the better investment option?
Anyone would say that Fund A is a better investment strategy and you should put more money there. But, what if you were to learn that the initial investment in Fund A was INR 25,000 and INR 2,000 in Fund B.
By applying the ROI calculation formula above, the ROI on Fund A and B are found to be:
Fund A ROI = (30,000 -25,000)/25,000 *100 = 20%
Fund B ROI = (5,000- 2,000)/2,000*100 = 150%
So, by the looks of it, Fund B here has a much higher ROI than Fund A, which explains the importance of considering the cost of investment before calculating the ROI.
Now that you understand the concept of ROI and how it is calculated, do you think you should always invest in schemes and funds which give a higher ROI? The answer to this lies in your risk appetite.
Does Higher ROI Always Mean Good Investment?
A higher ROI is always attractive, but what investors fail to understand is that the higher the risk, the higher the ROI is. So, if you are risk-averse or would not like to invest in risky investments, then stay away from the lure of high ROIs. A detailed fundamental and technical analysis of the investment opportunity is required to assess whether the investment’s high ROI is due to its healthy performance or due to high risk. An investment that has a higher risk like equity tends to reward its investors with higher returns but that might not be suitable for all classes of investors. For seniors who are looking to invest their retirement funds, equities and high-risk products are not the right choices. Thus, chose the investment option wisely after studying the ROI along with the risk involved.
Another important characteristic of ROI is that the longer the investment period is, the higher the ROI will be. This is true for equity investments, real estate, as well as FDs. Time plays an important role in the calculation of return on investments. An INR 80 lac investment in a flat might fetch you approximately INR 83 lac on re-selling after 2 years, whereas the same flat would sell for INR 90 lacs after 6 years due to appreciation in real estate prices. In this case, the ROI on the flat after 6 years is much higher than after 2 years. Thus, while investing, pay attention to the long run and invest money which you would not require in the next 1-3 years. This will help you earn more on your investments.
Investing is an art and very few have been able to master it. Understanding the market dynamics and the fine balance of demand and supply is crucial when it comes to making sound investments. So, keep learning and keep investing!
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