The concept of return on investment (ROI) --- that is, how much money am I going to make on my investment? --- is involved in any investment decision. ROI is the key piece of information you need to know to decide if the investment is worth the risk, as all investments have some risk. ROI is usually discussed in terms of an annual percentage.
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Calculating Return on Investment
To calculate return on an investment, you divide the annual profit by the total investment to come up with a percentage. If you invest £650 in a one-year certificate of deposit at 2 per cent interest, you will have £663 for an ROI of 2 per cent. But calculating ROI on other types of investments like stocks and bonds or real estate can become very complex and often requires the services of an accountant.
Higher Risk Equals Higher Return
The most important thing to remember about ROI is that higher risk generally equals higher returns. You can be guaranteed 2 per cent on your investment in a bank CD with almost no risk. Or you could make a 14 per cent ROI if you invest in a Canadian oil trust, but there is much more risk if the price of oil drops greatly or production is reduced for some reason.
Example of ROI on a Dividend-Paying Stock
ROI is reasonably easy to calculate for a dividend-paying stock. Say you bought 100 shares of a stock at £6 each (for a £650 total investment) and the stock pays a 60p per share annual dividend. After one year, you have a total of £715, for a 10 per cent ROI. Let's say the stock price also appreciated from £6 to £7. Then your total investment is worth £780, for a 20 per cent ROI. However, keep in mind it works both ways --- if the stock price goes down more than one dollar, you could even have a negative ROI.
Example of Real Estate ROI
Calculating ROI on a real estate investment is much more complex, as it involves many factors. Let's say you have excellent credit and you bought a house to rent as an investment with no down payment. You have a £975 monthly mortgage payment on the house ($18,000 annually), your total annual property taxes are £2,600 and your total annual maintenance expenses are £1,300, for a total of £15,600 a year. So if you charge £1,625 month in rent, you will bring in £19,500 a year; £19,500 minus the £15,600 total expenses equals £3,900 annual profit, or 25 per cent ROI.
Using Spreadsheets and Databases to Calculate ROI
Many investors find computerised spreadsheets and databases (Excel, Quicken, Access) very useful when calculating the ROI for complex investments, as the various factors can all be accounted for and tallied automatically.
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