Friday, February 5, 2010

Return on Investment Calculations

The calculation appears simple enough:
Return on investment equals what has been
earned divided by what has been invested.
If an investor puts $1,000 in a portfolio of
stocks that appreciates to $1,100 and pays
$50 in dividends, the portfolio would have
returned 15 percent ($150/$1,000).

However, it is not that simple. To
make the percentages meaningful,
investors need to consider
a few important variables.
For one, a $150 return
on a $1,000 investment in
one year is better than a
$150 return on a $1,000
investment over two years.
Indeed, the first outcome
produces a 15 percent annualized return,
while the second produces a 7.24 percent
annualized return. Annualized returns
enable direct comparisons.

Fees also matter. Two investors each
earn 15 percent on their $1,000 investment.
One investor is charged 1 percent of the
portfolio’s value at year’s end, while the
other is charged 2 percent. After fees are
subtracted, the first investor posts a 13.8
percent return on investment, the second
investor posts a 12.7 percent return.

Leverage, or debt, is another important
variable. Consider two $200,000 rental
properties: One investor pays the full price
in cash while another investor borrows 80
percent of the property’s value ($160,000) at
6.5 percent on an interest-only loan. After
one year, the property generates $15,000
in operating income. The first investor
earns 7.5 percent ($15,000/$200,000) on
his invested capital. The second investor
earns 11.5 percent [($15,000-$10,400 in
interest payments)/$40,000] on his invested
capital.

The variable of leverage,
in turn, leads to the variable of
risk. Some investments are
riskier (offer a greater
chance of losing money)
than others. A leveraged
investment is riskier
than a non-leveraged
investment; bonds are
riskier than stocks; futures
contracts are riskier than
stocks.

Bottom line: An 11.5 percent return
on a leveraged investment isn’t necessarily
better than a 7.5 percent return on an
unleveraged one.

Returns on investment are important
considerations, to be sure, but the variables
that contributed to those returns are just as
important.

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