Formula

• The return of an investment is simply the net gains or profits realized, divided by the amount invested. If you bought $10,000 worth of stock and sold your investment for $10,500, you will have realized a gain of $500. This figure must then be divided by the initial investment of $10,000 resulting in a return on investment (ROI) of 5 percent. Naturally, you can also lose money on an investment. In that case, the net loss must be divided by the initial investment and the figure reported as a negative return.
  
  

Risk-Free Rate

• When measuring the success of an investment, the ROI should be compared to the risk-free rate. The risk-free rate is the return that can be realized by lending money to the federal government. Since the government can always pay back its obligations by printing money, it has zero risk of default. The rate of return offered by government bonds is therefore considered to represent the risk-free rate. A proxy that can be used instead is the rate offered by large banks on government insured certificates of deposit. Since these, too, have a negligible repayment risk, the net return offered by your local bank can often be used as a key benchmark. If a given investment carries even a small repayment risk, it must produce a better ROI than the risk-free rate, since the latter can be obtained without assuming any risk whatsoever.
  
  

Worst-Case Scenario

• While it is easy to compare an investment to the risk-free rate, things get a little more complicated when comparing two risky investments. Assume you can lend $1,000 each to Joe and Bill, who promise to return you $1,110 and $1,150 in one year's time, respectively. As a security deposit Joe is willing to give you his old truck, probably worth at least $900, to keep until you get your money back, while Bill is happy to hand you his baseball card collection which can be sold for $500. In the worst-case scenario, you can sell the collateral and cut your loss to $900 if you lend your money to Joe and $500 if you go with Bill. The difference between the potential losses is a hefty $500, while the difference in returns is only a negative 0.5 percent, which is 11 percent minus 11.5 percent. This small difference is perhaps not worth the much higher risk, making Joe the better pick.
  
  

Effort

• The ROI on an investment must be worth the time and effort invested in the undertaking. If you estimate that you can earn 5 percent on your money by buying a parcel of land and expect to make 7 percent by purchasing stocks, the former may be the better choice after accounting for the significantly greater work that must go into following the stock market every day, assuming the investment carry comparable levels of risk. A parcel of land may require a visit a couple of times a year to make sure that no natural disaster has occurred. Those hundreds of hours you will spend on stocks, on the other hand, could be channeled into a productive project that will produce additional income or could be spent with your family.