Methodology

Investing Basics

Module 3

What is a portfolio?

Calculating Returns

Individuals make investment decisions with the intention of making more money. In order to ensure that this happens, it’s important for investors to calculate the return that they make from their investments.

 

A simple way to calculate investment returns is to use the return on investment (ROI) formula, which is: Net Profit ÷ Cost of the investment × 100. The outcome of this calculation will be the investors % return.

 

For example, if an individuals invests $10,000 and earns $1,000, the calculation would be: $1,000 ÷ $10,000 × 100 = 10%.

 

From this, an investor can say that they have generated a return of 10%. Typically, this calculation will be done on an annual basis, meaning that a 10% return has been achieved for a given year.

Removing expenses

In order to get an accurate ROI figure, it is necessary to remove all expenses from the profit achieved. Possible expenses include transaction fees, stockbroker fees or interest paid on a loan that was used to invest with. The most common expense will be transaction fees, as all investors pay a fee when they buy or sell an investment.

 

Although it is not advised, some individuals do borrow money to invest, whether it be from the bank or from a family member. Any interest paid on those loans should be removed from the profit earned from investing. For instance, if an investor achieves a return of $1,000 and pays $20 in transaction fees, $40 in stockbroker fees and $400 in interest to their bank, those expenses need to be subtracted from the return. This would mean that the investor made a return of $540.

 

So, if this return was achieved using $10,000, it would mean that the investor earned a return of 5.4% ($540 ÷ $10,000 × 100), instead of 10%.   As you can see, expenses can have a significant impact on investment returns. Therefore, investor should aim to minimise their expenses to maximise their return.

Calculating ROI over several years

If an investor holds an investment across several years, it can be unclear what the ROI would be for each year on average. It is necessary to calculate this average, for the purpose of measuring performance. It is important for an investor to know if an investment has been worthwhile or not, especially if they have held that investment for a long time. There is nothing worse than holding an investment for several years, only to find out that it wasn’t worthwhile after all. 

 

To calculate the average ROI for each year, when an investment is held for several years, you simple need to divide the ROI % by the number of years that the investment has been held for.  For example, if an investor invests $10,000 for 5 years and makes a profit of $15,000, the ROI would be 150% ($15,000 ÷ $10,000 × 100).

 

You then just need to divide the 150% by 5, as the investment was held for 5 years. So, the annual average return of the investment would be 30%.

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