How To Make GREAT Investment Decisions Using Return On Investment (ROI)
Updated: Jan 11, 2022
Return On Investment (ROI) is one of those things people say and perhaps understand on a theoretical level, but as with many things in life the practical application isn’t as straightforward. Get it right and you could be on a path to financial success but get it wrong and you could find yourself on the metaphorical equivalent of a stationary bike: pedalling furiously but going nowhere.
I had just completed my MBA degree from a relatively prestigious university and felt like a finance whizz kid. I could do required rate of return (RRR) calculations using the CAPM model and work out potential ROI. I could work out net present values (NPV). I understood how to calculate the beta for a stock. I thought I knew a lot but when it came to investing my hard-earned cash in the stock market or in property or something else, I realised that book smart doesn’t always translate to practical business smart. I accepted that I was in fact a smart dummy and so I came off my high horse and started learning about the practical realities from whatever source I could. Would you believe I actually bought a book titled Investing for Dummies? I still have it on my bookshelf. I’d encourage you to adopt a similar mindset as you read the rest of this article. You never know, you just might pick up something you have not considered before.
ROI is the starting point for all investment decisions
In simple terms, Return On Investment is a way of assessing the pay back of an investment decision relative to the amount invested. The calculation is net profit divided by the cost of investment. For example, say I travelled to Brazil on holiday and after chilling on the beach with a pina colada, decided to go shopping and found that havaiana flip-flops were incredibly cheaper than in London. Then decided to buy 30 pairs of flip-flops for the equivalent of roughly £5 each = £150. Then managed to sell them in a car boot sale once I was back in London for £12 each = £360. My ROI would be (£360 - £150) / £150 = 140%. Not too shabby at all. In absolute terms, I would have made £210.
I might be super excited until when one of my mates, who was on the same beach with me sipping on a dirty martini, tells me that he bought Brazilian hair for £150 and sold it for £600 once back in London. His ROI would be (£600-£150) /£150 = 300%. That’s £450 in absolute terms….Yikes!!!
Given that we were on the same beach, at the same time and assuming the time investment was the same, it means I missed out on a potential £240 (£450 - £210). We can call this the opportunity cost of my investment decision. With prior knowledge of the options available to me while soaking up the sun, I most likely would have gone for the Brazilian hair investment.
At the most basic level, investment decisions can be this simple
Chase the investment that gives you the biggest ROI.
I have saved £2,000 and want to invest it. Shall I invest in one big tech stock where historical returns have been 10% a year, yet knowing the standard stock warning that past performance is no guarantee of future results? Perhaps I could partner with a few friends and buy an investment property that generates 8% return a year. How about the Brazilian hair business: I could book a cheap flight to Brazil and buy lots of hair with my £2,000 and make 300% return.
Wait a minute, what about that email I received from a prince in trouble with his uncle, who needs a temporary loan of £2,000? He is promising 700% return in 3 months. OK that’s a bit too risky – maybe I shouldn’t. I have a better option: my friend, with no experience in property has just launched a property company specialising in ‘HMO’ and ‘Rent to SA’ and is promising 15% return a year. Actually, I saw adverts for beach resort homes in Bulgaria, Dubai, Spain and Egypt – this is minimal hassle as they’ll manage it for me and generate rental profits of 20% a year. How about that restaurant I always dreamt of starting? £2,000 could be what I need to start a street market stall. The return is only 2% a year, but it is my dream and I know I can grow the business. Oh dear, all this sounds too scary. Maybe I’ll just leave £2,000 in a ‘high interest’ savings account that’s not even matching inflation – My ROI might be –0.3% but at least my money is ‘safe’.
These are the decisions we make all the time. Some are more open than others about their thought processes, but every single working adult with a bit of money saved will have these money thoughts. The power of ROI is that it allows you to use one metric across a broad range of investment categories. You are chasing the biggest return possible that fits your investment criteria.
I have deliberately included some scamy examples, which might make you laugh and say: “that would never happen to me” All I can say is that there are some super smooth tongues out there and you are not immune to their charm. Slightly off-topic but I think it might be helpful to outline 3 simple rules I’ve developed over the years to save me from myself.
3 Simple Rules to Reduce the Risk of Being Scammed
I NEVER invest in schemes from cold callers.
Massive RED FLAG is when you put me under pressure to make a decision for a large investment in a short space of time. I politely WALK AWAY
I discuss ALL my investments with a TRUSTED circle of EXPERIENCED friends BEFORE I invest
I would now like to drill down into 6 factors to consider when looking into the ROI of a potential investment
1. Try to Use a Consistent Method for ROI Calculations
One massive problem with ROI calculations is that different people work out the net profit (the numerator of the ROI equation) in different ways or one person would work out net profit very differently for different investments. For example, in the Brazilian hair example, some would include the cost of marketing the hair via etsy or facebook marketplace and others would not. Some would include the time involved in taking pictures of the hair and creating the advert, the cost of posting and packaging e.tc. Others would only include some elements of this.
Property investment is particularly prone to this problem. When investors are talking to each other, they’ll talk about gross yields and net yields and ROI. If you get the chance to look at their spreadsheets, you’ll discover that they’re often not factoring the same things in their calculations and therefore a deal generating 10% ROI for one person may actually equate to 6% based on another person’s deal analyser. It is really important to pick a method and apply it consistently so that you can accurately compare different investments. I have included an example of a ROI calculation for a real life, plain vanilla, Buy To Let property within my portfolio as an example below. Other investors may choose to include the mortgage product fees (also known as mortgage arrangement fee), which could be as much as £1,999 and tends to be added to the loan. Some may choose to factor potential void periods.
Note that this ROI calculation only includes rental income. It was actually a below market value (BMV) property. Although I was sceptical about it being BMV at the point of purchase and made the purchase decision primarily based on rental return, I was subsequently able to re-mortgage and release some value within 2 years of purchase, despite no movement in house prices in the area. The retrospective ROI was thus much higher.
Trying to use a consistent method is not as straightforward as it might seem. Take the two most popular asset classes: Stocks and Shares vs Property for example. In property, you generate rent and the equivalent metric would be dividends for shares. Yet not all shares pay dividends and so how do you work out the ROI? If you argue that shares could go up in value, I would say that that’s not guaranteed just as I would say that property is not guaranteed to go up in value.
Moreover, in property, you should ideally invest for cash flow (see example above) and future growth is a bonus. So, at the point I’m making a decision to buy a FTSE 100 index tracker for example, for consistency, I’d need to only include the dividends in the ROI calculation. 5 years later, if my FTSE 100 index tracker has grown 6% a year, I could retrospectively work out the ROI by factoring the 6% a year value increase and the dividend paid out per year. The equivalent in property terms would be a combination of the net rent per year and the increase in value of the property.
2. You need to Value your TIME
Your OWN time is the most precious ‘commodity’ to you as it is LIMITED in supply. What is the value of your time? Take the Brazilian hair investment generating 300% ROI for example. If you had to visit 10 hair salons a day for 2 weeks to sell half of the hair would you still rank this investment as being better than the havaiana flip-flops investment generating 140% ROI? Say you found a property for £100k requiring refurbishment and you calculated that the ROI upon completion of the project was 10% (i.e. £10k). Would you still be excited if it meant that you would need to commit your evenings and weekends to the project for 6 months?
The average working adult trades time for money in the form of a salary and therefore at the very least, you could work out roughly how much you earn per working hour and use that to cost your time. Of course, the interconnected world we live in provides opportunities to turn 1 hour of your OWN time into 10 hours of OTHER peoples’ time, but that’s a story for another day….
3. Be clear about the TIME HORIZON of the investment
Would you rather invest in a project delivering 10% ROI in 6 months or a project delivering 15% in 12 months? It is important to consider the investment time horizon when comparing the ROI of different investments. This is actually related to a core principle of finance: £1 in your hand now is worth more than a £1 in the future (aka the Time Value of Money). This is because the £1 received today can start earning interest immediately and with compounding, could be worth more than the £1 in the future, particularly if that future is many years away.
Of course, the other problem is inflation, which means that the buying power of that future £1 could be more like 90 pence in today’s money. People tend to think of inflation in negative terms but do you know that YOU and INFLATION could actually be best buds for certain types of investments? Take Buy to Let property for example. Rents tend to rise with inflation and can even beat inflation. Therefore, an inflation busting income stream is servicing the mortgage debt. But guess what’s happening to the size of the loan over the 20-year life time of the mortgage. Yes, you guessed it – inflation is eroding the value of the loan.
4. Decide how to account for LEVERAGE
You have £25,000 to invest and you place it in the stock market and generate returns on that £25,000. If you decided to invest in property, that £25,000 could ‘magically’ turn into an investment pot of £100,000 thanks to the relative ease of getting a mortgage. Now you have the potential to generate a return (or loss – just saying) on £100,000. When working out your potential ROI, you will need to decide how to account for leverage.
5. Don’t forget to consider the TAX implications.
I’ll start by stating that the tax Tail should NEVER wag the investment Dog. Allow your creative mind to think about investments first and then consider the tax implications later. In my property ROI example above, I did not break it down to ROI after tax, but perhaps I should have. After all, if I had invested the £39,379 into an ISA (over 2 years), there would be no tax to pay on any profits.
Tax is a complicated subject and there are so many angles to consider. Your ROI after tax could vary significantly depending on your personal situation. Are you a basic rate tax payer in your main job or a higher rate tax payer? Did you set up your property business in your own name or in a limited company? Does your investment allow you to draw profits just under the capital gains tax allowance threshold each year or not? Does your project allow you to claim for capital allowances? Is your partner also working and does the investment allow you to optimise your combined personal allowances and basic rate of tax? Does the investment qualify as an EIS ? Are you making the most of tax wrappers (e.g. ISAs, SIPP, SSAS)?
6. Have an understanding of your RISK APPETITE
I think that most people implicitly understand risk. A newbie to cryptocurrency may consider an investment in bitcoin more risky than investing in a US index tracker fund. This needs to be factored into the ROI calculation and can be thought of as the likelihood of the spreadsheet ROI calculation materialising as a real ROI by the end of the investment time horizon. In corporate finance, there are various complicated models for estimating risk, but they are not very practical for individual small-scale investors.
A good, simple starting point could be to formally risk rate your investments on a scale of 1 to 10, where 1 is least risky and 10 is very risky. It is also helpful to understand your risk appetite, risk tolerance and capacity for loss; search the internet for free calculators to help with this. I recall ‘investing’ or shall I say gambling with a low 5 figure sum on an individual stock and not being able to handle it when it dropped just 4% and so I sold it out of fear. The stock subsequently rose 20%. However, I’ve invested 3 figure numbers in individual stocks and not batted an eyelid when it dropped 30%.
Sometimes the perception of risk is down to lack of knowledge and/or experience. Therefore, if after doing your ROI calculations, you consider that it is the perceived risk of the investment that has made you choose a different investment on this occasion. It is worth trying to increase your knowledge of the investment you decided not to pursue.
That’s it for this post. I hope you’ve found it insightful.