Return on investment

Return on investment is a key concept to understand when you’re investing. Essentially, it’s the rate of return you get on your investments, which determines how much your money grows by.

You can apply the concept of return on investment to shares, funds, a property purchase, or anything else you might have invested in. Hopefully, your return on investment is positive. But it can be negative, if your investment makes a loss.

When looking at shares and funds that you hold (for instance, in an ISA), you can calculate the return on investment for each individual holding. Then by combining them, you can work out the return on investment for your entire portfolio.

What is return on investment in simple terms?

Put simply, your return on investment is the gain, or loss, you make between buying or selling an investment such as a share or fund.

If you haven’t sold an investment yet, you can still calculate the return on investment to give you you a figure for how well it’s done to date. You can then compare that figure with other investments you’ve made.

Return on investment is similar to another term you may have heard – the rate of return. However, the rate of return often refers to the return on investment you get over specific time periods (most commonly a year), rather than the whole period you’ve held an investment. But the two terms are often used interchangeably.

How do you calculate return on investment?

Calculating your return on investment can be anything from very straightforward to quite complex. To help, here’s an example.

Let’s suppose an investor has bought 100 shares in a company for £10 each, then sold them for £13 each. To calculate the return on investment, we first take the initial outlay, then deduct that from the total proceeds of the sale of the investment. This gives us the total profit from this investment in cash terms.

This is a pretty simple example. In the real world, you might need to factor in not just price growth, but also dividends, interest, taxes and costs to arrive at a more accurate figure.

What is a good rate of return on investment?

This is, of course, the $64,000 dollar question. The glib, but most accurate, answer is how long is a piece of string – because there is no commonly agreed figure that qualifies as ‘good’. But to help you work out what would make a good return on investment for you, here is what you can consider.

First, think about the rate of return you can achieve net of all taxes and charges. In other words, you should factor in the costs that reduce the amount of money you’ll get at the end of your investment. For instance, shares and funds can be held in a Stocks & Shares ISA to protect them from taxes, but an investment property can’t.

Also, it almost goes without saying that the higher your return on investment, the better. However, high return investments tend to be associated with higher risks. Or to put it another way, an investment that has a chance of delivering a very high return, probably also has a chance of delivering a very high loss, especially over shorter time frames.

A good recent example is cryptocurrencies like Bitcoin, which have moved both up and down very sharply, creating big gains for some people, and big losses for others. So it’s important to assess the prospective rate of return on your investment in relation to the risk you have to take. When doing this, remember your investment goals, and consider how much risk you’re comfortable taking to meet them. And set this in the context of what investments are available.

For example, let’s say you’re choosing between a low-risk asset like cash that yields 1% a year, and a higher-risk investment expected to deliver 6% a year. The latter’s significantly bigger rate of return goes some way to rewarding you for the extra risk you need to take. However, if the low-risk asset yields 5% a year, that higher-risk 6% investment suddenly doesn’t look so tempting. You’re not getting much extra return on investment for the additional risk you need to take.

Generally speaking, the longer you hold an investment, the longer it has to grow, to ride out the peaks and troughs of volatility and deliver a higher return on your investment. You should however, always remember that the value of investments can change, and you could lose money as well as make it. For example, in the stock market the rate of return you’ll get over one year can be anything from very bad to very good. But over time, the range of outcomes tends to narrow. So in the long run, the stock market is more reliable, and has historically been one of the best places to invest over extended time periods.

If you’re thinking about investing in the stock market, a good rule of thumb is that you should be willing to leave your money invested for at least five to ten years – so you can ride out the ups and downs in search of positive returns.

Episode 8: How to make money from investing

So how, exactly, does investing make you money? Our experts dig into the two main ways you can compound your returns as an investor: growth and income.

Listen to our Investing Essentials podcast

Will I know what my return on investment is in advance?

Few assets offer a specific return on investment in advance. That’s because investment returns are, by their nature, variable and unpredictable.

It’s important to recognise that the return you receive on an investment may not be replicated in future. So be wary of extrapolating your gains (or losses) in a straight line.

Exceptions to this rule are cash and bonds. But even here, your returns aren’t without some risks. Government and corporate bonds, for instance, offer a fixed rate of return, provided you hold them until maturity. But there’s always the chance that the bond issuer becomes insolvent and unable to repay your capital and interest in full. This is more likely for bonds issued by companies. Developed market governments like the UK and the US are very unlikely to be unable to pay their debts.

Another potential risk with bonds is if you sell before its maturity date. When you do this, you’ll only ever get the market price, which might be more or less than you paid for it. So in this case, the return on investment isn’t known in advance.

So what about cash accounts?

Though usually thought of as savings rather than investments, cash accounts are worth mentioning because you’ll often want to compare cash rates with the returns you might get from higher-risk investments.

Cash accounts offer a rate of return that’s known in advance, but it’s usually a variable rate, meaning it can change at the drop of a hat, for better or worse. So in this scenario, you only really know what you’re getting paid in interest here and now, rather than, say, over the next five years.

Some cash accounts offer a fixed rate of return if you lock your money up for a certain time period, typically one, three or five years. This gives you certainty about the interest you’ll receive, except in the extremely unlikely circumstance that the bank becomes insolvent and can’t pay back the deposits it’s taken from savers. Why don’t you take a look at our cash savings hub accounts, where all our accounts are protected by the Financial Services Compensation Scheme (FSCS) covering up to £85,000 per bank.

Over the long term, the rate of return of a cash account will tend to be lower than a riskier investment, like the stock market. However, cash is safer, which makes it more suitable for money you only want to tie up for a short period of time.

Find out what our Head of Personal Finance, Laura Suter, had to say when we asked her, should I save or invest?

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