Return On Investment - Do You Know Your Numbers?
You’ve been following your stock trading plan to the letter. You’ve integrated portfolio diversification, implemented a plan for stock technical analysis and started using Japanese Candlesticks for your stock trading system. You have even executed Strangle Buys and even Bear Call Spreads. But since the most important thing is the bottom line, have you graded your results? What exactly is your Return on Investment?
It is quite important to know and understand your Return on Investment. This calculation reflects your performance in the stock market. First, every investor needs to know how well he or she has performed against their stock investing system. If the results are good, the trading plan is working. If the results are poor, changes to the trading plan may be necessary. A diversified portfolio is great, but if it isn’t generating a return, something needs to change. Second, calculating Return on Investment is good, but do you know how to do it in a meaningful way?
There are several calculations that will give you an idea as to whether you are a successful trader. Some are more complicated than others, but none are above conquering with a standard calculator. Several of the calculations you can use to help you understand your Return on Investment are:
This stock analysis calculation is actually simple; it contains a reminder that it is necessary to include dividends (where appropriate) when figuring the return of a stock. The calculation is as follows: (Value of investment at the end of the year – Value of investment at beginning of the year) + Dividends / Value of investment at beginning of the year = Total Return. For example, if you bought a stock for $10,000 and now it is worth $12,000, you have an unrealized gain of $2,000. During this particular year, you also received dividends of $500. What is the total return? ($12,000 - $10,000) + $500 / $2,500 = 25% Total Return. Since it is not based on actually sales, you can use this calculation for any time period but it will not reflect a growth rate for long term investing.
Simple Return is similar to Total Return; however it is used to calculate your return on an investment only after you have sold it. The calculation is as follows: Net Proceeds + Dividends / Cost Basis – 1. For example, you bought a stock for $2,000 and paid a $12 commission. Your cost basis is $2,012. You sell the stock for $3,000 and there is another $12 commission, so your net proceeds are $2,988. Dividends amounted to $250. ($2,988 + $250 / $2,012) - 1 = 61% Simple Return. Like the Total Return calculation, the Simple Return tells you nothing about how long the investment was held only if it was a successful trade or not.
Compound Annual Growth Rate
For investments held more than one year, it could be this calculation could be more of an accurate reflection because it shows the time value of a Return on Investment. This is important because 25% Return on Investment in one year is impressive, but a 25% Return on Investment in ten years is not exactly stealing from the stock market. For example, after making a $1,000 investment two years ago, it is now worth $1,500. To calculate the CAGR for this example, you take the nth root of the total return, where "n" is the number of years you held the investment. In this example, you take the square root (because your investment was for two years) of 50% (the total return for the period) and get a CAGR of 22.5%.
Understanding a Return on Investment is important for an investor who wants to make money investing in stocks. By understanding the Return on Investment, a trader can know what is working in his or her trading plan and what is not working. The bottom line defines the investor and Return on Investment is that bottom line.