Decoding ROI: What does return on investment really mean?

Let's talk about something super important in the finance world — Return on Investment, or ROI. It shows investors how well their investments are doing.

In simpler terms, ROI measures the gain or loss on an investment compared to the amount of money you put into it. Whether it’s a lemonade stand or stocks, ROI helps you figure out if you're achieving a positive return. 

In this guide, we'll break down the key factors you need to understand ROI. Learn what to consider when you evaluate an investment, the types of ROIs out there, and how to calculate them for different types of investments.

Investigating investment essentials 🕵️‍♂️

Before you jump into investing, there are a few key things to consider. Imagine you’re a detective in the world of money — you need to look at all the clues to make the best decision.

Risk level

If you had to choose a new video game to play, how would you pick? Some games are easy and relaxing, while others are super challenging. Investing is similar. Some investments are low risk, like a bike ride through the park. They're safer, but the rewards might be smaller.

On the other hand, high-risk investments are like skateboarding down a steep, winding hill — exciting, but you might take a tumble. It’s crucial to figure out what kind of risk you're comfortable with. Are you the type to play it safe, or are you ready and more willing to take risks for potentially high rewards? 

Time horizon

This investing concept is similar to planning how long a road trip will be. If you’re saving up for something in the near future, like a new gaming console or a concert ticket, you’re looking at a short time horizon. These investments need to be safer, as you don’t have much time to recover from potential losses. 

Long-term goals, like saving for college or a car, allow you to go for investments that might have ups and downs but grow significantly over time. If you plant a tree, it takes time to grow tall and strong. 🌳

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Investment type

Choosing the best type of investment for you is similar to picking a character in a video game — each has its strengths and weaknesses. Some stocks, essentially shares of ownership in a company, are for adventurous heroes on quests that can bring great rewards but also come with risks. They fluctuate in value based on the company's performance and market conditions, offering the potential for high returns or significant losses. Bonds are more like the reliable sidekicks — usually safer but with smaller rewards. They're loans investors give governments or corporations that earn fixed interest payments over time. This makes them a steadier, more predictable investment. 

Real estate is like building and managing your own kingdom — it requires more effort and capital but can be pretty rewarding. This involves purchasing property to rent out or sell at a higher value, offering both rental income and the chance for capital appreciation. Then there are things like mutual funds and exchange-traded funds (ETFs), which are like a team of different characters that each add their strengths to your portfolio. Mutual funds pool money from many investors to buy a diversified portfolio of stocks, bonds, or other securities, managed by a professional. ETFs are similar but trade like a stock on an exchange, offering flexibility and ease of trading. Both options allow investors to diversify their investments across a wide range of assets with a single transaction.

Picking the right type depends on your goals, risk tolerance, and time horizon. Some investors even look outside of purely money-focused goals, including socially responsible investing. 

Investment objectives

Choosing your goals — what you want to achieve with your investments — is like setting the final destination for your road trip. 

Do you want to maximize short-term savings, or are you in it for the long haul? Do you want to generate a steady income, quickly grow capital, or diversify your portfolio? These objectives will determine the route you take in your investment journey. Having a clear goal helps you strategize better and makes the journey more enjoyable and rewarding.

Types of ROI

ROI isn’t one-size-fits-all; it comes in different forms. Once you understand these different types, you’ll become a more informed investor.

Absolute ROI

Plain and simple. Think of absolute ROI like measuring your height growth in a year with pencil marks on the door frame. It reveals your investment's total increase or decrease within a specified timeframe. Basically: Did your money grow or shrink? Pretty straightforward.

Relative ROI

On the flip side, relative ROI is comparable to gauging your highest game score against global leaderboards. It examines how your investment fares compared to a benchmark or standard, such as a stock index. This can help you determine whether your investment leads the pack or needs a kickstart. 🏆

Formula for calculating ROI

Ready to crunch some numbers? 🧮 The formula for figuring ROI is pretty simple:

ROI = (Net Profit / Investment Cost) × 100

Net profit is the difference between what you gain from your investment and what you initially put into it. If the number is positive, you've gained a profit, and if it's negative, you've experienced a loss.

Investment cost is the total amount of money you’ve used to purchase an asset, such as stocks or real estate. This can include fees, commissions, and taxes related to the purchase. Now let's take a look at some ROI calculations for different types of investments. 

Money market accounts

Money market accounts are a form of savings account that offer higher interest rates, making them well-suited for short-term financial goals due to their low-risk nature. Determining the ROI for these accounts boils down to the interest you’ve earned and any fees you’ve paid.

Consider this scenario: You deposit $10,000 into a money market account with an annual interest rate of 3%. After one year, your account accrues $300 in interest, and you’ve paid a $25 account maintenance fee. Your net profit is then the difference between your interest earned and fees, which comes out to $275 ($300 - $25). To calculate ROI, you simply plug in the numbers: ($275 / $10,000) × 100 = an ROI of 2.75%.

Stocks

ROI is much more dynamic when it comes to stocks. The calculation involves assessing how much the stock price has changed since your purchase, any dividends received, and any fees paid in the process. You also have to make the distinction between realized and unrealized gains.

Realized gains are profits that have actually been realized through the sale of a stock at a higher price than it was purchased for. Unrealized gains, on the other hand, are increases in stock value that you haven’t cashed out yet. Typically, unrealized gains are not included in ROI calculations as they can fluctuate and are not guaranteed until actually realized.

While it may seem like you need a lot of money to get involved with stocks, micro-investing has made it possible to start with small amounts. Some apps, like Greenlight’s investing app for kids, even allow you to buy fractional shares. This makes it easier to diversify your portfolio by investing in multiple companies with a smaller amount of money — as little as $1.

Bonds

Another popular investment option is bonds, essentially loans made to companies or governments. For bonds, ROI revolves around the interest earned (coupon payments) and any shifts in the bond's price if you decide to sell it before it matures. If you hold onto the bond until maturity, you'll receive your initial investment back, and you’ll also get interest payments over time.

For instance, let's say you acquire a $1,000 bond and receive $50 in interest each year until the bond matures after ten years. At that point, you've collected a total of $500 in interest and will also get back your initial investment. To calculate total ROI, we can use this formula: ROI = ($500 / $1,000) × 100 = 50%.

However, these types of investments are typically shown with annualized ROI, which considers the length of the investment. A common formula for this is:

Annualized ROI: = [(Ending Value ÷ Beginning Value) ^ (1 ÷ Number of Years)] – 1

Plugging in our previous numbers:

Annualized ROI: = [($1,500 ÷ $1,000) ^ (1 ÷ 10)] – 1

Annualized ROI: = 4.14%

This calculation shows that the annualized ROI for this bond investment is 4.14%. This may seem lower than the initial ROI of 50%, but it takes into account the time frame and provides a more accurate representation of the return on investment. In many cases, there may also be additional investment costs to consider, such as fees or taxes, which can affect the overall ROI.

Real estate

Real estate investments introduce a strategic element to ROI calculations. Here, you need to consider rental income, property value fluctuations (appreciation or depreciation), and the expenses related to acquisition and maintenance. It's like playing Monopoly in real life, where you calculate your earnings from the houses and hotels you've acquired. 🏠

Become a financial virtuoso 💰

Congratulations! You've just learned all about Return on Investment (ROI) and are now ready to make informed investment decisions. 

📚 Recap of key takeaways:

• ROI basics: ROI serves as your financial scorecard to track the performance of your investments in terms of gains or losses.

• Investment fundamentals: Approach it like a detective by considering risk levels, investment types, time horizons, and objectives.

• ROI types: Familiarize yourself with Absolute ROI (direct growth tracking) and Relative ROI (comparing your performance to benchmarks).

• Calculating ROI: Dive into the formula and apply it to various investment categories, including money market accounts, stocks, bonds, and real estate.

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Ready to put all this knowledge to use? Dive deeper into the investing world with Greenlight’s investing app for kids and teens.

Greenlight gives you the tools to learn, grow, and succeed in the exciting world of investing. So, what are you waiting for? Let's turn those investment dreams into reality… one smart decision at a time!

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