The limitations of ROI
So, ROI is very easy to understand and brings a universal measure of profitability. Are there any limitations? Sure.
One of the biggest limitations of ROI is that it doesn't take into account the time period. Why does this matter? Well, time is a crucial factor for investments. There could be other considerations (like liquidity and security), but if an investment brings 0.5 ROI in a year, that's better than 0.5 ROI in five years. This is why you may see some talking about annualized ROI, which represents the investment returns (gains) you could expect over the course of a year.
Still, ROI won't take into account other aspects of an investment. A higher ROI doesn't necessarily mean a better investment. What if you can't find anyone willing to buy your investment and get stuck with it for a long period of time? What if the underlying investment has poor liquidity?
Another factor to consider is risk. An investment might have a very high prospective ROI, but at what cost? If there's a high chance that it goes to zero, or that your funds become inaccessible, then the prospective ROI isn't all that important. Why? The risk of holding this asset for a long time is very high. Sure, the potential reward could also be high, but losing the entire original investment is certainly not what you want.
Just purely looking at ROI won't give you insights into its safety, so you should consider other metrics as well. You could start by calculating the risk/reward ratio for each trade and investment. This way, you can get a better picture of the quality of each bet. In addition, some stock market analysts may also consider other factors when evaluating potential investments. These can include cash flows, interest rates, capital gains tax, return on equity (ROE), and more.
We've looked at what return on investment (ROI) is and how traders can use it to make more informed investment decisions. The return on investment formula is a core part of tracking the performance of any portfolio, investment, or business.
As we've discussed, ROI isn't the ultimate metric, but it can be useful. You also need to consider opportunity cost, risk/reward ratio, and other factors that may have an impact on your choice between different investment opportunities. As a starting point, however, ROI can be a good barometer to evaluate a potential investment.