The term “return on investment” (ROI) is frequently used, but its true meaning and calculation are often misunderstood. This article provides a clear explanation of ROI and demonstrates how to accurately calculate it, empowering you to make informed financial decisions.
Three Common Methods for Calculating ROI:
1. Cash-on-Cash Return: This method focuses on the return generated directly from your initial investment. For example, if you invest $20,000 and it yields a $10,000 profit, your cash-on-cash return is an impressive 50%. This is a strong indicator of effective wealth building.
2. Total Investment Growth: This approach considers the total value influenced by your initial investment, especially when leverage is involved. If you invest $20,000 as a down payment on a $200,000 mortgage, the investment’s growth is calculated based on the $200,000 value. While this shows the potential impact of your investment, the actual return on your initial capital is often more relevant for assessing performance.
3. Opportunity Cost Analysis: When seeking external funding, demonstrate the potential gains the investor might miss by not participating in your venture. Illustrate how your investment, offering a 20% return, outperforms their current investment yielding only 5%. Highlighting this difference underscores the value of investing with you.
Wealth Building Strategies of the Affluent:
The wealthy typically cultivate specialized areas of expertise – real estate, stock market investing, or their own businesses – to generate substantial returns. After accumulating wealth, they prioritize capital preservation by investing in lower-risk assets like bonds or treasury bills, accepting returns in the 3% to 5% range. They strategically limit high-risk ventures to fields where their expertise provides a significant advantage and a reasonable expectation of profit.