Return on Investment (ROI) Explained

Introduction

Hardly is there any sight so satisfying as to see one’s investment multiply. But sometimes we tend to calculate our returns incorrectly. The term “return on investment (ROI)” can be defined as the percentage ratio that compares the net profit or benefit gained from an investment to the original amount of money invested. It is a highly useful financial metric to evaluate how well an asset class is performing. Hence it is also an effective method to compare different assets. In the volatile world of cryptocurrencies, ROI is not just necessary. It is essential.

A crypto coin with a higher ROI is generally better than the one with lower or negative ROI. But a higher ROI is not always as attractive as you may think. There are many reasons which will be made clear in this article as you read on.

Why You should Measure the ROI

It is obvious why you should look at the ROI of an asset: it is required so that you can decide where you are likely to get better returns. You can look at different coins classifying them into different categories, narratives, chains, etc. However, measuring the ROI is also necessary after you have made your investment because you can hold yourself accountable as to whether you have made right decision or not. You can apparently feel satisfied, but numbers may tell another story. So, measuring the ROI can provide you with an objective and unbiased reading of the performance of your investment.

How to Calculate ROI?

Quick-View Method

So far, it is clear that ROI is a gauge of how well your cryptocurrency is performing. There are a few quick ways to find it out. For example, when you open the “Info” or “About” section of a coin in your portfolio, the section shows you an estimate of weekly, 10D, fortnightly and monthly ROI. If the value is positive, the coin has performed well. A negative value shows that the coin is struggling, demanding you either to do a dollar cost average (DCA), or sell to cut losses, so that you may not go down with the ship.

By Observing Charts

Another method is to look at the chart at different time frames. Charts show you the full story beyond only 30 days that you can get from the method mentioned above. Simple and exponential moving averages, trend lines, chart patterns, relative strength index and volume candles can tell you whether your coin is alive or dead. This analysis is all the more necessary in the crypto market as many coins that you hold for a long term may sometimes lose the use cases or the transaction volume.

By Using the Formula

Additionally, you can use a standard calculation procedure to do the whole thing on your own. Suppose you bought a new coin on an exchange, and it did not perform well later on. You bought it for $1000. The current market price gives you a net asset value of $50. You can use the following formula to calculate your ROI.

ROI = (current value – original cost) / original cost

ROI = ($50- $1000) / $1000

ROI = -950 / $1000 = -0.95

When you multiply the result with 100, you get the percentage value. (-0.95 X 100 = -95%). Hence your ROI is -95%. You have incurred a drastic loss in the coin. This is the drawback of investing in a new cryptocurrency. It is against the principles of risk management to invest so large an amount in a low cap coin. Above all, you have incurred the loss in a year, making the annualized ROI horrendously hideous.

Now take an example of your investment in Bitcoin, the largest cryptocurrency in the world. Imagine that you invested $1000 in $BTC when the coin was being traded at $53500 exactly a year ago. The current market price of $BTC is around $118,000. Let’c calculate your ROI.

ROI = (current value – original cost) / original cost

ROI = ($2205- $1000) / $1000

ROI = 1205/ $1000 = 1.205

1.205 X 100 = 120.5%

With an ROI value of 1.205, or 120.5%, your investment is more than doubled in a year. This is the power of the cryptocurrency market when you do proper technical and fundamental analysis and exercise appropriate risk management.

Drawbacks of ROI Values

As you know there is nothing perfect in this world. So is the case with the notion of ROI, its calculation and application. There are certain drawbacks that you need to keep in mind.

Inflation

Factors of Time and Inflation play their role in making an ROI value practically useful. If a coin gives you 1.205 ROI in a year and another coin gives you 1.5 ROI in 3 years, the former value is better despite being lower. Therefore, the higher is not always the better when we evaluate ROI.

Difficulty in Materializing the Returns

Moreover, it is also possible that an asset is providing you a mouth-watering ROI, but it is difficult to sell and materialize the gains. Although it does not happen in the crypto market, you can equate this problem with that of applying the past ROI records to the future. For example, a coin may have been among the most reliable ones till now, but due to any reason it can crash.

Risk-Reward Ratio

It brings us to the last point: the risk-reward ratio of the coin. When you see a coin featuring among gainers constantly, you may be tempted to buy it due to its attractive ROI values. But when you study the details of risk-reward ratio, you come to know that the upside potential is quite limited, and the downside potential is very deep. Again, a higher ROI value does not necessarily mean the asset is of high quality.

Conclusion

In nutshell, Return on Investment (ROI) is a handy measure to evaluate the performance of your investment as well as that of any asset in which you are interested. It is calculated by subtracting the original net asset value from the current value and then dividing the answer by the original investment. Despite being a productive tool, it can be misleading if you take inflation and risk-reward ratio into account.