What is Return on Investment (ROI)? 

What is Return on Investment

Canadian Investors have different investing strategies, but they all share one common goal: to earn as much money off investments as they can. 

One way to measure the profitability of an investment is to look at its return of investment (ROI). What exactly is ROI, how can you calculate it, and how can you maximize it? Let’s take a closer look at this metric and see. 

What is return on investment (ROI)? 

Return on investment (ROI) is a metric (usually a percentage) that measures how well your investments are performing. With ROI, you can calculate how much an investment might earn for every dollar you invest, which can help you decide which investments will work harder for you. 

ROI can be super helpful when you’re comparing the returns between similar investments (like two different tech stocks, for instance, or two mutual funds) or when you’re trying to evaluate the efficiency of your own portfolio. 

How can you calculate ROI? 

Calculating ROI is pretty simple. The most basic formula looks like this: 

ROI = (Ending value of investment – Initial value of investment / Investment cost) x 100

For example, let’s say you invested $10,000 in a mutual fund with a 1.5% management expense ratio (MER). By the end of the year, your investment grows to $11,000. Minus the MER ($150) and your initial investment ($10,000), you’ve earned $850 in your first year. Not bad, right?

Well, let’s see what that looked like as a ROI. 

($11,000 – $10,000 / $10,150) x 100 = 9.85%

So, you could say your mutual fund has a ROI of 9.85%. Considering that the TSX/S&P Composite Index has a historic return of 8% to 9%, that would definitely make a great ROI. 

What are the limitations of ROI calculations? 

While ROI is often super helpful, it does have its limitations. Perhaps the biggest is that simple ROI calculations don’t factor in time

Why is that a limitation? Consider this: you’re looking at two investments. Investment A has an ROI of 12%, while Investment B has an ROI of 11%. Naturally, you’d think Investment A will provide a better bang for your buck, right? 

Well, when you take a closer look, you see that it takes Investment A a full six years before it reaches an ROI of 12%. And Investment B? Well, it takes B only three years to hit 11%. In this way Investment B would be the better option. 

Another limitation is market risk. Many investors make the mistake of looking at ROI as a figure set in stone. It’s not. At its best, ROI is simply a forecast of what investors might expect to receive. 

That means, an investment’s posted ROI isn’t a guarantee. You could earn more than that. You could earn less. An ROI may help you see which investments have historically earned more than others. But it can’t tell you which investments will earn more in the future. 

ROI Pull Quote

How can you maximize your portfolio’s ROI? 

When it comes to maximizing ROI, keep in mind: you can’t control everything that affects it. Market prices will go up and down, and though you may pick great stocks today, you can’t predict what will happen to those stocks tomorrow. 

There are, however, several strategies you can implement to help you maximize your returns over time. Here are five you can start practicing today. 

1. Invest consistently  

Perhaps the best way to improve your ROI is to invest consistently over a long period of time. That means making regular contributions during both bull and bear markets. 

While, yes, it can feel counterproductive to put money in a portfolio that’s dropping in value, your contributions can minimize the drop. At the same time, because stock prices are low during a bear, you can buy more stock at a much lower price. When the bull comes back (it always does), you’ll capitalize on immense gains as the market makes a comeback. 

Similarly, don’t stop making contributions during a bull market, either. Just because your portfolio is soaring in value doesn’t mean you should get complacent about contributing more. 

To help you stay invested in bulls and bears, consider practicing dollar-cost averaging. With dollar-cost averaging, you invest the same amount every period (monthly, quarterly, yearly) no matter who the market performs. In practice, you’ll buy fewer shares when prices are high, but more when prices are low. This helps balance market lows with highs and ensures you’re investing consistently for the long-term.  

2. Reduce investment costs 

ROI isn’t all about increasing your earnings. Often, one effective way to maximize ROI is simply to reduce your investment fees.

For example, let’s say you invest $20,000 with monthly contributions of $500 into three different funds. Fund A has an investment fee of .20%, Fund B has a fee of .75%, and Fund C has a fee of 1.5%. If we assume an 8% average annual rate of return, here’s how much you’ll have in each fund after 30 years. 

  • Fund A: $872,994 
  • Fund B: $779,229
  • Fund C: $668,608 

As you can see, the difference between a .20% fee and a 1.5% fee—though seemingly small—could result in a difference of $204,386 between two funds. Yeah—that’s crazy. 

To minimize investment fees, compare trading commissions and management fees for different online brokerages. In fact, with so many high quality discount brokerages in Canada—not to mention many low-cost funds, such as ETFs—you can reduce your investment fees by a significant amount simply by choosing the right brokerage and investments. 

3. Take advantage of tax efficient retirement accounts 

Like investment fees, taxes can eat into your portfolio’s earnings. While you won’t be able to escape paying taxes, you can cut your tax bill simply by placing your investments in tax-sheltered retirement accounts.

Two accounts you should definitely use are the Tax Free Savings Account (TFSA) and the Registered Retirement Savings Plan (RRSP). With a TFSA, you use after-tax dollars (money that’s already been taxed) to fund your account. Your investment earnings will grow tax-free, meaning you won’t have to pay taxes on them in retirement. With an RRSP, you use before-tax dollars (money that’s taken from your paycheques before taxes are applied). Like a TFSA, your earnings will grow tax-free, though because your contributions are before-tax, you’ll pay income taxes when you withdraw the money in retirement. 

4. Diversify your portfolio 

Diversification is a big word that can mean a number of different things. For stocks, diversification means having money invested in numerous companies, sectors, and even countries in order to minimize risks, capitalize on growth, and maximize ROI. 

If you invest in only one sector’s stocks (say, retail stocks), you’re at the mercy of that sector’s performance: all it takes is one nasty market crash—for retail stocks, it was the pandemic—to crush your portfolio. By investing in different sectors, however, you’ll minimize risks, since not all sectors are impacted by market volatility in the same way. 

Stock diversification is one way to help your ROI. Another way is to diversify your assets. That means investing in more than just stocks: real estate, bonds, commodities, currencies, even cryptocurrency. Again, when you spread your money across numerous assets, you hedge risk: the stock market may crash, but your real estate investments may hold strong. 

5. Think long term 

Finally, keep a long-term perspective on ROI. Many beginning investors make the mistake of believing they’ll see an immense return in a short period of time. Others, wanting to get rich quick, will engage in risky investing strategies, such as short selling or timing the market. While these strategies can be lucrative if you know what you’re doing, they can also cause you to lose a lot of money. And when you’re trying to maximize ROI, losing money is about as backward as you can get.