Return on investment (ROI) along with risk are two critical methods in evaluating investment performance. The holy grail of investing is to achieve high return on a low risk investment. In our investment analysis, we try to find companies which can provide attractive returns given the risks of the business and time horizon.
Return on investment calculated as:
Income / Investment = ROI
Income used in ROI calculation can vary between investments. For business this could be Net profit which is Revenue – Expenses (cash and capital depreciation). For investors this could be Dividends + Interest + Change in share prices over the time horizon.
It is important to note that ROI needs to be adjusted for time period before judging which is the attractive option. If an investment has high ROI for 6 month but another with lower ROI for 3 years. Adjustments must be made so they can be directly compared.
Table below shows the Investment Return across a number of investment options.
ASX 200 can be used to represent the overall equity. The return in the last 12 month is at the lower end of the historical range. Investors can capture equity market returns through passive investment vehicles such as index funds. The return figure is the net capital gain and includes the dividend paid.
Long term return of Australian equities average around 9.5% over the last 20 years. There may be periods of high volatility just like post Tech bubble collapse, GFC and end of commodity super cycle. For long term investors who can ride out the market volatility. The dividend yield on the investment is just as important as the potential capital gain.
We did not include international shares like S&P 500 Index Fund which can provide investors international equity exposure. International share return also include a foreign exchange risk as total return for Australian investors are susceptible to changes in the Australian dollar. EUR to Australian dollar risk if the investment is priced in Euros.
Fixed income return is based on 10 year average return. Return on fixed income investment is driven by credit risk as represented by the credit spread and the underlying risk free rate. Note this would be lower going forward due to current low interest rate environment.
10 Year Bond yield can be a proxy the risk free rate of return. It is the current yield for investors that own on the run 10 Year Australia Government Bonds.
RBA cash rate is indicative of return on cash.
We have included rental yield estimate for the residential investment as a proxy for real estate returns before capital gains. Long term residential investment average around 9.8%.
The investment options above does not take into consideration the tax impact which can skew the return profile. Dividends with franking credits can improve overall equity return. For real estate investments, additional factors can come into play like if the property is positive geared or negative geared.
Investment Return vs Risk
It is important to understand return on investment within the context of risk taken to achieve those return. High risk investments must compensate investors with a high return on investment while it is a given that low risk investments means low ROI.
The table above shows that as ROI fall, the return also fall. Equity being the lowest component of the capital structure has the highest return while the 10 year yield is slightly higher than cash rate due to the long term nature of the investment.