Return on investment, or ROI, is a profitability ratio used to measure the profits, amount, or rate of return generated by an investment. Whenever the return on investment is positive and in the normal range of 5 to 7%, it is considered to be a good return. If the ROI exceeds 10%, it is considered a strong return.
Generally speaking, after accounting for inflation, when an investment generates a return of 7%, it is considered to meet expectations based on past market trends and performances.
In this article, we will understand what a good return on investment is, how to calculate ROI, its limitations, and the impact of inflation on your returns.
A good return on investment
A good return on investment indicates that the gains from an investment exceed its initial cost, signifying profitability. A good ROI does not have a thumb rule as it can depend on various factors. The most important among these factors is your financial goal.
For instance, imagine a young couple investing to cover college tuition for their newborn. A good ROI would allow their initial and subsequent investments to grow sufficiently over 18 years to cover future college expenses.
Consider another example. You earned a 5% return from a fixed deposit in a reputable Indian bank. Although it does not seem impressive, this is a safe investment since you face no market risks. Now, imagine you achieved the same 5% return after spending the past year closely monitoring and trading in the highly volatile stock market based on tips from social media. In this scenario, the 5% return is less appealing because you had to endure significant risk and likely experienced considerable stress during the market's ups and downs.
How to calculate ROI?
If you want to calculate your return on investment, the first step is to divide the net profit or the amount you earned from your investment by the cost of the investment. Afterwards, you need to multiply it by 100. The result will give you the percentage of returns.
You can calculate ROI by using the below-given formulas:
Return on investment = (Net profit from the investment / Cost of the investment) x 100
Or
Return on investment = (Present value of the investment - Cost of the investment) x 100
Let us understand this formula better with an example,
Mr. A invested a sum of Rs. 10,000 in a company a few years ago. He sold his investment of shares in the company, and it was now worth Rs. 13,000. To calculate the ROI he earned, we will use the following formula:
ROI = ((Rs. 13,000 – Rs. 10,000)/Rs. 10,000) x 100 = 30%
The return on investment for Mr. A in the company is 30%. However, this calculation does not consider any expenses or fees incurred either while buying or selling the shares or any other capital gains that might have applied to the sale.
The percentage we get after calculating ROI can be easily compared to other ROI percentages across different asset classes to compare and understand which asset class gives good yields.
How to use ROI?
The return on investment metric has many use cases. It is used widely by investors to analyse and understand the performance of their portfolio or to compare and gauge the efficiency of any expenditure.
For example, a business owner invests Rs. 10 lakh to start a new assembly line in his factory. As a result, he could do more sales of Rs. 1 Crore since he had more inventory. He earned a 900% return on investment due to the new assembly line.
Let us take another example of a software company that develops software worth Rs. 25 lakhs to expand into new markets. The company earns Rs. 35 lakhs in revenue in the first year after developing the software. The company successfully generated an ROI of 40% by developing the new software product.
When using ROI, it is important to remember that the accuracy of your calculation depends on the reliability of your input data. ROI does not account for risk or uncertainty. When making investment decisions based on ROI, it is crucial to consider that your profit estimates could be overly optimistic or too conservative. Additionally, past performance does not guarantee future results.
Long-term vs Short-term investments
Long-term investments benefit from the power of compounding and are best suited for goals such as retirement and wealth creation. However, they come with their fair share of highs and lows.
Short-term investments are useful for taking care of any emergency requirements or when you need a considerable sum of money to make down payments. Although these investments are safe, they offer a low rate of return.
Here’s a quick look at their key differences:
| Long-term investments | Short-term investments |
| Typically held for several years | Held for a few months to a couple of years |
| Less liquid, harder to convert to cash quickly | More liquid, easier to sell or cash out |
| Higher return potential due to compounding | Lower return potential |
| Ideal for retirement, education, and wealth accumulation | Suitable for short-term goals like vacations or emergency funds |
Examples of Long-term investment
- Stocks and shares: Investing in initial public offerings, blue chip stocks, and other promising shares of companies will give the investor a chance to participate in the company's growth story. However, since the investment in stocks is linked to the markets, there could be significant fluctuations and occasional negative earnings.
- Real estate: Real estate can be an attractive long-term investment since property prices continue to rise with time based on historical performances.
- Target-date funds: These funds invest in multiple asset classes like shares, stocks, and bonds with pre-decided maturity dates. Target date funds will automatically adjust your risk profile when your target date is nearing and make good investment options for long-term goals.
Examples of Short-term investment
- Savings accounts: They make for good short-term investments as you also earn some extra interest and have the flexibility to withdraw your money at any given point in time. Some banks also provide insurance on your deposits, making them a safe investment.
- Certificates of deposit: Considered to be one of the safest low-risk investments, certificates of deposit keep your money locked in for 6-18 months, depending on the period you choose. You can deposit your money either with a bank or a credit union, which will pay you slightly higher rates than a savings account.
- Treasury bills: These are suitable for your short-term goals or parking surplus funds. Although they offer lower returns compared to long-term investments, they are very low risk, as they are backed by the government.
What if your investment is performing below its average?
The markets are dynamic, and there can be times when your investment is not performing at par with your expectations. During such times, the rule you must remember is not to panic and stay composed.
The markets can give exceptional returns in one quarter, and the next quarter can come crashing down. So, it is important to take both the highs and lows with a pinch of salt. If earning average returns is your goal, you need to not give into the market sentiment and stay invested even when the indices are not performing at their best.
All high-risk investments like stocks and real estate can turn negative during market downturns. However, if you are looking at the long term, these investments more than make up for the lost value and generate higher returns that fulfil your investment objective. This was the reason why you invested in these assets in the first place.
Understanding inflation’s impact on your returns
Inflation needs to be closely monitored as it affects the rate of return on your investment.
If the rate of return on your investment is 5% and the inflation is growing at 6%, your real rate of return on investment is negative. This is because the growth of your capital was not able to keep up with the rise in prices; hence, it underperformed.
Cash investments mostly stay close to the rate of inflation or trail slightly behind. The same applies to cash deposits and savings account deposits. The value of money will grow based on the interest rate provided by the bank, but in the long run, the buying power of that money will reduce.
So, if you are a young professional planning for long-term goals like your child’s education or retirement, you should allocate a larger part of your investments toward stocks and shares. Based on historical data and performances, they offer a time-tested way to build your wealth and beat inflation. During periods of high inflation, it's crucial to identify the best investments to protect against the erosion of purchasing power.
What is considered a good ROI for investing?
The definition of a good ROI varies depending on the kind of investment, financial goals, and the risk-return appetite of the investor. Here are some general guidelines you can follow to decide whether the ROI justifies the investment:
- A positive ROI in the range of 5-7% is generally considered good enough and is a reasonable expectation to have from your investment. If the ROI is greater than 10%, it is considered to be a strong ROI.
- If you are investing in stocks, a 7% return after adjusting for inflation is considered to be optimum.
- If you invest in mutual funds, the average return for 10 years in India is 20%.
- Investments in bonds generally fetch around 4 - 6% returns.
- Gold, being a highly popular investment option among Indians, is seen as favourable when it generates more than 5% ROI.
- Real estate investments are considered successful if they realise 10% or more returns.
- If you are investing in alternative investment options like cryptocurrencies and peer-to-peer lending, it is fair to expect a return of double digits given the high amount of risks that come associated with these investments.
Calculate your investment growth with our mutual fund calculator.
Limitations of ROI
Although the ROI metric is widely used across industries by investors and financial experts to understand profitability and what is a good return on investment, it comes with its own set of limitations:
- ROI does not take into consideration the concept of the time value of money. ROI calculations overlook the timing of cash flows. For instance, a short-term high-return investment might be less profitable than a long-term lower-return investment. Therefore, ROI does not consider the risks related to cash flow timing.
- ROI does not lay any emphasis on the amount of the investment. If you get a high ROI on a small capital, it might not be impactful enough as the returns will not be very significant.
- ROI also fails to take into consideration the risk profile of an investment. Two investments might share the same ROI, yet one could carry much more risk. In such cases, the higher ROI might not be worth the additional risk.
- ROI does not factor in external market conditions that can affect the performance of an investment, which in turn impacts profitability.
Conclusion
ROI remains one of the favourite tools of investors and analysts alike for making informed decisions. By calculating the ROI from different investment avenues, investors can compare different options and choose the one that aligns best with their requirements. Although ROI comes with its own set of limitations, it remains a good indicator of the overall performance and effectiveness of an investment.
By carefully assessing your investment options and considering both short-term and long-term goals, you can achieve a good ROI that aligns with your financial objectives.
Mutual funds are an excellent way to achieve a good ROI because they pool money from many investors to invest in a diversified portfolio of assets. For those looking to maximise their returns while managing risk, consider exploring the mutual fund schemes available on the Bajaj Finserv Mutual Fund Platform. You can compare 1,000+ schemes and use handy tools to make the best investment choices.
