Question

A friend tells you that his investment return on a specific mutual fund has been +10%, +20%, and -25% over the last three years. He says he is happy that he made 5% on his money during this time. What concept of investment returns does he not understand?

Answer 1

Return on investment is the profit expressed as a percentage of the initial investment. Profit includes income and capital gains. Risk is the possibility that your investment will lose money. With the exception of Treasury bonds, which are considered risk-free assets, all investments carry some degree of risk. Successful investing is about finding the right balance between risk and return.

Historical return on investment is the annual return of an asset over several years. Research analysts and professional investors use historical returns, along with industry and economic data, to estimate future rates of return. You can use actual results and estimated returns to evaluate various assets, such as stocks and bonds, as well as different securities within each asset category. This evaluation process helps you pick the right mix of securities to maximize returns during your investment time horizon.

Return on Investment (ROI) is a performance measure, used to evaluate the efficiency of an investment or compare the efficiency of a number of different investments. ROI measures the amount of return on an investment, relative to the investment’s cost. To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio.

The return on investment formula:

ROI = (Gain from Investment - Cost of Investment)/Cost of Investment

ROI can be used in conjunction with Rate of Return, which takes in account a project’s time frame. One may also use Net Present Value (NPV), which accounts for differences in the value of money over time, due to inflation. The application of NPV when calculating rate of return is often called the Real Rate of Return.

Here in the mentioned scenario, the person is happy that he made a net return of 5% on his money during the time frame of 3 years, however he is ignoring the concept of Net Present Value (NPV) and Real Rate of Return (RRR).