Many traders buy/sell various assets every day but few of them have an idea of how to estimate correctly the quality of their investments.
Professional traders quite often use ROI (Return On Investment) — an index that helps to assess how fully your investments have paid back, which, in the end, will allow the investor to make money in the long run. Also, ROI is used for efficient investments not only in business but in any financial assets. Mathematically, ROI is the relation of the net profit to the investment.
What is the ROI needed for?
Talking about real business, this index helps to estimate your investments in the long run. And if the trader or investor wants to sell the profit from selling the securities, ROI helps to compare different companies and see which stocks will be more profitable.
Thus an investor can compose their portfolio of the most stable companies, regardless of market fluctuations. To estimate investments in stocks, we can take any security and see on its example, what ROI we will get.
An example of ROI for Amazon
For example, at the beginning of the current year, one stock of Amazon cost 1,840 USD. We buy one — this is the size of our investment.
In November 2020, the stocks are sold for 3,310 USD each. Thus, by buying a stock in January 2020 and selling it in November of the same year, we earn 1,470 USD of net profit. Let us calculate ROI: divide 1,470 by the sum of your investment (1,840) and multiply by 100%.
Here we need to realize that if your ROI is larger than the interest on a bank deposit, you can be confident investing in this company — provided that the stock price of the company will keep growing, and the company will pay dividends.
However, if ROI drops lower than the interest on a bank deposit, try to avoid such investments. This might mean a deep market decline.
In our example, thanks to the growth of the stock price, ROI turned out to be extremely high. Of course, we must realize that the market may correct, and the index will in reality be lower.
Which ROI is good for you?
As for real business, ROI higher than 10% is considered the optimum. If ROI is lower, it will be easier to put your money into a bank deposit.
Investing in the currency, stock, or crypto market, ROI may turn out to be negative. More often, most experienced traders are more than ready to invest in underpriced assets.
As a small example or an idea of looking for such opportunities, have a look at the crypto market. It frequently slumps deep down, and assets stay long in downtrends. It seems interesting to study the maximum negative ROI of such moments and consider buying only in such situations. Thus we will follow the guidance of such greatest investors as Warren Buffett and buy assets not on the top of the market but in deep drawdowns. For example, starting at the beginning of the year, the rate of the Bitcoin fell from 9,000 USD to 4,000 USD with ROI at - 50% at that moment. If we bought the leading crypto asset at the maximal price we could sell it several times cheaper some months later, which is not at all profitable.
On the other hand, this might be a signal that the moment to buy the asset is now because its price has dropped significantly. Next, exit the market when ROI reaches 50%. Anyway, an experienced trader can estimate such a situation without calculations.
The main advantages of ROI
First of all, we can say that the calculation is simple. Investments in a company or the profitability of the stocks of several companies can be compared quickly and easily. Thus you will be able to spread your investments evenly.
We can say that ROI is the best solution for a quick assessment of a business or a company on the whole.
Next, the analysis of history. We can fast and easily estimate the correctness of one's investments.
The main drawbacks of ROI
ROI does not account for the time factor, i.e. it is not quite clear which period you should calculate the index for, and how much your results will depend on this.
For example, ROI may be good for several years but poor for the period from the beginning of the year. This is for the investor to decide and account for various time data. It might be useful to make your own research and single out your preferred time factors.
We never account for all the data and expenses. As a rule, you are not always able to collect all the necessary digits in a large company. On the other hand, in the stock market, expenses can include various commission fees or the difference between buying and selling prices. Many investors note that this index will be absolutely useless for complicated markets.
Unfortunately, we do not calculate the potential profit but get a value for a certain period. It would be interesting to find the perspective of a couple of upcoming years to see the ROI level of these or those periods.
Some say that ROI is an extremely popular coefficient nowadays, most often used by a marketing expert. It is also worth researching in various financial markets by investors themselves.
As in the example with the crypto market, we can calculate an ROI that will signal potential buys and highlight that the market has fallen significantly, so you can open long positions. However, we can just estimate the drawdown itself and its deepest parts that signal the beginning of growth as well.
Hence, this index, like any other, can give us hints and ideas that we can use for better work. Unfortunately, ROI is most interesting to those who just calculate for estimating their investments.