A return on investment is simply how much money an investor makes on the money he invests, expressed as a percentage. If he invests $100,000 and makes $10,000, the return on investment is 10 percent; if he loses $10,000, it is a negative 10 percent return. Measuring a return on investment shows how well or how poorly an investor did, and whether the investment was worth the risk.
Annualized Return
To make comparisons easy, investors annualize returns. If investment A had a 30 percent return and investment B had a 15 percent return, A sounds better than B. But if A took a three year period to achieve, while B only required six months, then A has an annualized return of 10 percent and B has 30 percent. The problem with annualizing short-term returns is that there is no assurance that the good performance will repeat or continue.
For example, if a trader gets 20 percent in a stock in three months, which is 80 percent annualized, the question is whether the stock will appreciate another 60 percent and if the trader can repeat this return in other stocks. Alternately, if he loses 10 percent on his next trade, it will pose the same dilemma.
Risk Factor
Investor A and investor B both have a 20 percent annual return on their investments but investor A trades futures while investor B has his money in a diversified growth and income mutual fund. Investor A is taking much more risk with his money than investor B. As long as the returns are the same, risk does not become a major factor but trading futures is inherently a lot riskier than owning a diversified mutual fund -- in a bad year, investor A could lose 50 percent or more while investor B may be down only 10 or 20 percent.
Source of Profit
Closely related to the question of risk is the source of profit. If an investor invests in a bond or a dividend paying stock, the bulk of his return comes from regular interest or dividend payments, but investment returns from stocks and many other financial assets come from capital appreciation -- changes in the prices of assets. Interest and dividends come regularly and the investor gets to keep them, but capital appreciation may or may not occur, or may disappear as easily as it occurred.
Realized vs. Unrealized Gain
You can't say for certain that you have a profit until you sell your investment. Your stock may be up 30 percent in a year, but if you don't sell it and the stock declines to where you bought it, your return on investment is zero.
