Just as calculating trading profits is an important skill to possess so is calculating the “return on investment”. It’s important to know what your return on investment is as it is a performance measure which let you know how you and your trading systems are doing. This performance measure also allows you to compare your trading performance with the standardized measures of performance of such as the S&P 500 index.

Return on investment is also abbreviated as “ROI”. It is also referred to as “rate of return” which is abbreviated as “ROR”.

To calculate ROI, we must first calculate profit. In its simplest form profit can be calculated as follows:

Profit = current investment value – initial investment value

Let’s take a look at an example:

Current investment value = $50,000

Initial investment value = $25,000

Profit = $50,000 $-25,000 = $25,000

Note: The above example was created for the purposes of illustration only and does not include any transaction costs or fees.

Now we’ve taken a look at a simple calculation of profits, let’s use the same information above in our ROI calculation.

ROI = (current investment value – initial investment value)/initial investment value

($50,000 $-25,000)/$25,000 = 100%

The 100% shown in our above examples represents a 100% return on our investment. By having return on investment expressed as a percentage it makes it easier for us to compare one investment to another. Measuring ROI allows us to evaluate our performance, whether we have a $10,000 portfolio or a $10 million portfolio.

What we’ve just seen as an example of a single return on investment without any time period specified. In order to compare one return on investment to another we need to know over what period of time the return on investment was achieved. For instance, if one investment yields 100% per year ROI and another yields 100% per 10 years, then clearly the 100% per year investment has a superior yield.

Two terms that are often confused in the investment and trading world are the “annual ROI” and the “annualized ROI”. The annual ROI is the return on investment for a particular year as shown in the example below:

Annual ROI for each of 4 years

2010 = 10%
2011 = 15%
2012 = 20%
2013 = 25%

For 2010 the annual ROI was 10%, for 2011 the annual ROI was 15%, and so on.

Some use the above data and attempt to calculate the annualized ROI by taking the averages of the returns over the past four years as follows.

(10% +15% +20% +25%)/4 years = 17.5% per year

Let’s take a look at how to properly calculate the annualized return on investment in this scenario:

Annual ROI for each of 4 years

2010 = 10% = $25,000 X 10% = $2500
2011 = 15% = $27,500 X 15% = $4125
2012 = 20% = $31,625 X 20% = $6325
2013 = 25% = $37,950 X 25% = $9487.50
Total profit = $22,437.50

In our example above, we are taking into account that we are earning a return on our end of the year equity for the next year. In 2010 we started off with $25,000 and earned a 10% return for total equity of $25,000 + $2500 = $27,500. The $27,500 becomes our equity on which we will earn 15% in 2011. In 2011 we start off with $27,500 and earn a 15% return for a total equity of $27,500 + $4125 = $31,625. The $31,625 is now the equity that we start with in the year 2012.

Annualized ROI = $22,437.50/$25,000 = 89.75%/4 years = 22.4375% per year

Annualized ROI = $22,437.50/4 years = $5609 .375 profit per year

$5609.375/$25,000 = 22.375% per year

Our annualized ROI is 22.375% per year

So you can see our annualized ROI of 22.375% is greater than the 17.5% per year that could easily have been calculated using the first method. There is a scenario in which the first method could’ve worked and the annualized ROI could’ve been 17.5%. This method would involve starting with a $25,000 initial investment and removing the profits from our account at the end of each year. This means that each year would start with $25,000 and the return on investment from each year would be calculated based upon $25,000. The example below illustrates this.

Annual ROI

2010 = 10% = $25,000 X 10% = $2500
2011 = 15% = $25,000 X 15% = $3750
2012 = 20% = $25,000 X 20% = $5000
2013 = 25% = $25,000 = X 25% = $6250
Total profit = $17,500

Annualized ROI = $17,500/$25,000 = 70%/4 years = 17.5% per year

Annualized ROI = $17,500/4 years = $4375 profit per year

$4375/$25,000 = 17.5% per year

For more information on calculating trading profits and losses see: Calculating Trading Profits and Losses