ROI is a simple metric to you discover your profitability.
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Every thriving business relies on a robust return on investment (ROI) to help gauge whether its investments are yielding a profit. Although you as an individual investor possess shallower pockets than most businesses, your goal as a retirement investor is the same as a business. In this piece, I apply ROI to retirement investments and tell you what ROI means, how to calculate it, the different types, its limitations and how to use it to help you achieve an abundant retirement.
What Is Return On Investment (ROI)?
Return on investment “is a metric used to denote how much profit has been generated from an investment that’s been made. In the case of a business, return on investment comes in two primary forms, depending on when it’s calculated: anticipated ROI and actual ROI,” noted Harvard Business Review Online.
To calculate ROI, you take the actual or estimated income from a project and subtract the actual or estimated costs, according to HBRO. That number is the total profit that an investment has generated or is expected to generate. You then divide that number by the costs.
Here is the formula: ROI = (Net Profit / Cost of Investment) x 100.Net profit is the current value of the investment minus the cost of the investment. So, for example, if you made an investment of $10,000 and later cashed out with $15,000, your ROI would be 50%. ($15,000 – $10,000/$10,000 x 100.)
You can adjust the HBRO formula and apply it to your retirement investments.
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Why ROI Is Important In Retirement Planning
Think of ROI as a snapshot of how your investments are doing.“ ROI gives you a micro-level view of your performance, whether on a weekly, monthly or [on an] annual basis, and helps align your strategy with your retirement objectives,” Michael Kodari, CEO of KOSEC Securities, told me.
“An investor can determine if they are on pace to reach their retirement goals by periodically examining the return on investment of their portfolio,” Steven Kibbel, CPF, senior editor of the global funds transfer company InternationalMoneyTransfer.com, told me.
The Basic Return On Investment (ROI) Formula
To determine your ROI, start with a formula, like the one above.
The financial services firm the Center for Financial Planning in Southfield, Michigan, uses what are called “Monte Carlo Simulations,” conducted through a proprietary Raymond James version of Money Guide Pro for planning to determine the ROI investments would need to achieve, Angela Palacios, its director of investments, told me.
The simulations, named after the Monte Carlo Casino in the gambling mecca of Monaco, runs more than 1,000 different scenarios to deliver possible outcomes. “The actual ROI comes from the combination of investment assets we put together, stock allocation versus bond allocation and cash,” she added.
Different Types Of ROI Calculations
Review the different types of ROI calculations, below, to determine which may give you the most accurate reading of your retirement savings.
Annualized Return On Investment (ARR)
The annualized rate of return (ARR) is simply what it sounds like: it is “a way of calculating investment returns on an annual basis,” according to the Corporate Finance Institute. Here is the formula:
How to calculate annualized rate of return.
Corporate Finance Institute
Net Annualized Return (NAR)
Net annualized return on Investment (NAR) gets you closer to how much you realize from the investment. It is “used to measure the annual rate of return on an investment after accounting for all expenses, fees and losses, according to the peer-to-peer lending platform Mintos.com.
To reach the NAR, you start with the initial investment amount, added Mintos.com, add any returns or gains generated by the investment over a time period, deduct any expense, fees or losses incurred during the same time and calculate the annualized return by modifying the return or loss to an annual rate.
Real Rate Of Return
The real rate of return factors in inflation and taxes to determine the real loss and profit from an investment. In a post by CFP Brenden Flaherty on the site for the Boston Institute of Finance site, affiliated with Bryant University, here is the formula:
- Take the difference between the nominal rate [the total rate of return earned on an investment before adjusting for any deductions and premiums] and the inflation rate as a whole number, then divide by 1, plus the inflation rate as expressed as a decimal.
- If the total return (nominal) is 12%, and the inflation rate is 4%, then 12 – 4 = 8, and 8 divided by 1.04 = 7.692
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How To Calculate ROI For Stocks
To calculate ROI for stocks, follow the straightforward formula below, Kodari told me.
* ROI = [(Final Stock Price – Initial Stock Price) + Dividends] / Initial Stock Price x 100.
Kodari used the example of buying a stock for $50, which rose to $60 a year later and also paid a $2 dividend. The ROI would be:
• ROI = [(60 – 50) + 2] / 50 x 100 = 24%
He added that while the calculator offers a clear picture of your stock’s performance, you need to view it “in the context of market conditions, company performance and any reinvested dividends, which can further compound your returns over time.”
How To Calculate ROI For Bonds
Calculating ROI on bonds involves a different process than for stocks.
To do so, you must look at the bond’s coupon rate and the price you paid for the bond, Kodari told me. If, he said, the bond pays an 8% coupon and you bought it for $1,000, you earn $80 annually.
“If the issuing company’s financial health improves, the bond’s price can increase, and you can sell it for a profit. But in the bond market, finding a buyer is crucial, and transactions often involve bundling debt to appeal to institutional investors,” added Kodari.
How To Use ROI To Compare Different Investments
The benefit of using an ROI for different investments, such as stocks, bonds, real estate and savings accounts is that it gives you a uniform metric with which to compare them.
The Corporate Finance Institute used two examples to illustrate how the annualized ROI works and then compared the returns.
The first one is for a $100,000 investment into a high-interest savings account with a variable interest rate. Six years later, the account balance is $115,900 and the ARR is 2.5%.
The second one involved a Miami property bought for investment in 2015 for $350,000. Five years later, it was worth $410,000, which was an ARR of 3.2%.
The Limitations Of ROI
ROI is one tool for determining what kind of retirement you may have. Like many tools available for financial calculations, when used solely, it has drawbacks.
Using ROI without factoring in the inflation rate will not give you an accurate reading of your return in everyday dollars. “Inflation’s impact on ROI mostly goes underestimated. It’s not just about the diminished purchasing power of returns, but also about how inflation-adjusted ROI can keep one ahead in real terms.” Faris Khatib, CEO of the tax resolution and mediation company Ideal Tax, told me.
When focusing on ROI solely, you may overlook risk, market volatility and liquidity. “For example, a high return on investment could be extremely dangerous or hard to sell quickly. Not only does the growth of your money matter in retirement, but so does the stability and accessibility of those returns,” Kodari told me.
How To Project Your Retirement Using ROI
The experts who spoke with me encouraged using ROIs to project your retirement savings, while also noting the drawbacks of using it as the solitary measurement. Other critical measurements and factors include market volatility, your risk tolerance, inflation and need for liquidity as well as general health of you and loved ones who need to be covered by retirement funds.
“To anticipate how much income you’ll need in retirement, you can use expected ROIs to estimate how much your investments will grow,” Kibbel told me. “You can then figure out how much you may withdraw annually without running out of funds too soon, if your return on investment is low.”
Kodari added that you can use ROI as a benchmark to make sure you’re on track to meet retirement goals. If you’re earning 12% annually on $100,000, you’re growing that to $112,000 in one year, and with continuous reinvestment, your portfolio compounds further. Over 10 or more years, and with consistent contributions, you could see significant growth that gets you closer to your retirement goal,” he told me.
Using ROI Tools And Calculators
To come up with ROI on your retirement investments, take pencil to paper and use the formulas in this article or an ROI calculator, which are available online, such as the one from the finance services firm Edward Jones.
Bottom Line
Using ROI is one way to help you track your funds and gauge if they are working for you. “ROI is your speedometer for investing, so you should keep an eye on it regularly,” CPA Larry Pon of Pon & Associates in Redwood City, California, told me. “Just like the speedometer, you want to see how it is moving.”
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