What do we mean by ROI?
Essentially, it is what you get back in return for making an investment in a product, project or business.
Here are two simple examples:
1. Suzie sells name badges for a living. She makes $1 profit per tag. Each tag costs her $2 to make. By expressing Suzie’s profit as a percentage of the unit cost, her ROI is 50%.
2. Mr Greedy has $1000 to invest in a fixed deposit. A sales representative at his local bank informs him that he will earn $100 in interest after one year. Mr Greedy’s ROI is 10%. Note that banks will usually quote you an interest rate of 10% when promoting their savings or investment products.
The higher your ROI the harder your money is working for you and the more profit you will make.
The problem
Investment return calculations are highly flexible and can be easily manipulated to suit the user’s needs. When financial institutions advertise their products, they are going to tell you about great interest rates. It is only natural for these firms to sugar coat their investment returns to drive sales, which is why you need to ask one important question.
What is your net return?
Experts will quote you what is known as a nominal ROI on their products. This is the investment return before costs. That is all good, but you should be more concerned about the net ROI or return after costs.
Have a look at the following example:
Mr Return’s financial planner informs him that he can expect a nominal return of 10% on his investment portfolio. Inflation is 4%.
Firstly, this does not mean that Mr Return’s wealth will grow at 10% per annum. Secondly, it also does not mean that he will beat inflation by 6% (10% less 4%). If we look at his net return, it paints a completely different picture.
Nominal return: 10%
Less inflation: 4%
Less tax: 3.8%
Less annual management fees: 1.5%
Net return: 0.7%
What does a net ROI of 0.7% mean?
If you invest $10000 at 0.7% fixed investment return for 20 years, your real wealth will only grow by about $1500. And that is after 20 years!
Key lessons
1. Make sure you look at all the costs when assessing an investment product, project or business.
2. Determine your net ROI. Will your return enable you to achieve your financial goals at the given level of risk?
3. If your net return is not good enough, move on. Do not buy into a deal on the basis of nominal return.
4. Your goal as a wealth creator is to MAXIMIZE ROI at the LOWEST possible risk.
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