Let's start with the basics. What exactly is return on investment?
It's the amount of money you make on an investment relative to the investment's cost. This number, expressed as a percentage or ratio, is used to measure performance and compare the efficiency of different investments.
To calculate return on investment, the return on the investment is divided by the investment cost. The formula is gains minus cost, which is then divided by cost.
Return on investment is a simple and versatile way to gauge an investment's profitability. If an investment does not have a positive return, or if there are more opportunities available to invest in something that has a high return rate, these values can guide an investor to make better financial decisions.
One thing to remember, however, is the formula for return on investment doesn't factor in the length of time it took to collect your return.
If you don't know what kinds of returns are realistic for different types of investments, you may be putting your money at risk. Having this insight can save you from getting swindled. Don't be fooled by promises of, for example, returns of 15-20% or more.
Let's look at five categories of investments and what you can expect.
The first rule of investing is the higher the potential return, the greater the risk. Penny stocks are a great example of this. What you're doing by investing in these stocks is banking on a big return for something that could go either way.
There's no telling if one of these companies could be on the verge of a big breakthrough. It's complete guesswork.
Gold is another investment that could be seen as speculative. It's all about timing. If you reap the gains of gold before a crisis, you might make a lot of money.
If you get the timing wrong, however, your investment can go through a long and steady decline. For example, in 1980 the price of gold hit $850 per ounce. By 2001, the price dropped to under $300 per ounce, losing 65% of its value.
That's not to say necessarily gold is a bad investment, but if you decide to put money into it, it's probably best to do so as part of a diversified portfolio.
There are different risks involved in buying stocks and index funds.
Buying shares of stock in a business means you get a proportional share of the profits or losses. All of your money in that stock is tied to the company's success or failure. Short-term investments tend to be volatile.
With index funds, you're buying a bunch of stocks designed to track a certain index, such as the Dow Jones or S&P 500. Investors who buy into an index fund may own shares in dozens, or even hundreds, of different companies. You may not see the gains produced by an individual stock, but it's unlikely you'll lose all of your investment if things go south.
If you want to buy individual stocks and time isn't a factor, blue-chip companies are a good option. They're large, prestigious businesses with good earnings records and dividend payments in both good and bad times. Blue-chip stocks are seen as more stable with strong long-term growth potential.
Buying a rental property or any form of real estate can bring an excellent return on investment if you have time, patience and do a considerable amount of research beforehand. It's not foolproof—losses aren't uncommon—but there is a fortune to be made.
Real estate investing isn't a get-rich-quick scheme. The most successful property investors run their projects like a business and spend a good amount of time building them up.
Bonds historically have provided a solid return on investment, but it's good to know the key differences between individual bonds and bond funds.
Individual bonds have a finite maturity, which is the date you get your principal investment back and stop receiving fixed interest payments. Government bonds, for example, can be purchased with maturity dates from one month to 30 years.
If you hold an individual bond to maturity, fluctuations in interest rates do not impact your principal or interest payments. Selling before maturity, however, exposes these bonds to market risks. Depending on how much you paid for the bonds, the amount of interest collected and insurance rates, it can result in a profit or loss.
Bond funds pool your money with that of other investors, and a manager purchases bonds in accordance with the fund's stated investment goals. Maturity dates on these bonds are often staggered to provide frequent payments. The fund manager replaces bonds upon maturity.
Due to the fact bond funds don't come with a maturity date, you never know exactly when you earn back your original investment.
Inflation is the means by which the value of a dollar decreases over time. Historically, this has happened at clip of about 3% per year.
This can have a big impact on how much you earn from investments. If your return on investment is less than the rate of inflation, your investment is costing you money.
The money you make today won't be worth as much in the years to come. Any investment you make has to take that 3% into account.
If your expectations are reasonable, and you invest conservatively, you'll have a less stressful experience. Be wary of anybody who promises high returns, such as 20% or more. It's not going to happen, so don't let yourself get conned.
Investing isn't a science, and it's not perfect, but there's plenty of opportunities to make money if you're realistic about it. What is a good return on investment? It's is something that beats both inflation and taxes while building up your future
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