How do you calculate ROI?
ROI (Return on Investment) is calculated as: ROI = (Net Profit / Total Investment) × 100%. For example, if you invest $10,000 and earn $12,500 back, your net profit is $2,500 and your ROI is 25%. CAGR (Compound Annual Growth Rate) is more useful for multi-year comparisons.
Key Terms
- Alpha
- Returns above a benchmark index. If your investment earns 12% while the S&P 500 earns 10%, you have 2% alpha. Negative alpha means a passive index fund would have outperformed.
- Tax Drag
- The compounding reduction in wealth caused by paying taxes on annual gains or dividends. At 25% capital gains tax, your effective compounding rate is reduced by 25% annually.
- Expense Ratio
- Annual fund management fee as a percentage of assets. Even 1% annually reduces a 30-year investment by ~25% compared to a 0% fee alternative due to compound drag.
- DRIP
- Dividend Reinvestment Plan — automatically reinvests dividends to buy more shares, accelerating compounding. Historically adds ~0.5–1.5% annually to total stock returns.
- Leverage (Real Estate)
- Using borrowed capital to amplify returns. A $300k property bought with $60k down (5:1 leverage) means a 10% property appreciation gives you ~50% cash-on-equity return.
- FIRE Number
- The portfolio value needed to retire — typically 25× annual expenses (4% safe withdrawal rate rule). The Wealth Projector shows how long to reach your personal FIRE target.
Worked Examples
Example 1: S&P 500 Index Fund (10 Years)
Scenario: $10,000 lump sum + $500/month for 10 years at 10% average return.
Total invested: $10,000 + $60,000 = $70,000. Final value: ~$129,000. CAGR on total capital: 6.3% (accounting for staged contributions). MOIC: 1.84×.
After 3% inflation & 15% tax: Real after-tax CAGR ≈ 5.2%. Final real value ~$105,000 in today's purchasing power.
Example 2: Real Estate (Leveraged)
Scenario: $300k property, $60k down payment (5:1 leverage), 6.5% mortgage, $1,500/month rent, $400 expenses, 7% appreciation for 5 years.
Property grows to: ~$421k. Equity built: ~$161k. Net rent collected: ~$33k. Total return on $60k equity: ~223%. CAGR on equity: ~26%/year — this is the power of leverage.
Example 3: Why CAGR Beats ROI for Comparison
Investment A: $10k → $20k in 5 years. ROI = 100%, CAGR = 14.87%.
Investment B: $10k → $30k in 10 years. ROI = 200%, CAGR = 11.61%.
Investment B has 2× the total ROI, but Investment A has 28% higher annual compounding — and reinvesting A for 10 years would yield $39k vs B's $30k. CAGR tells the real story.
Understanding Return on Investment
Why ROI Alone Isn't Enough
Return on Investment is the universal language of financial performance, but raw ROI is often misleading. A 200% ROI sounds incredible — but was it earned in 2 years or 20? Without annualizing returns using CAGR, you cannot compare investments fairly. The most successful investors think in CAGR, not total ROI.
The Hidden Cost Triad: Inflation, Taxes, and Fees
Gross returns are rarely what you actually keep. A fund returning 10% annually with a 1% expense ratio, 15% capital gains tax, and 3% inflation delivers only about 5.1% in real after-tax returns. Over 30 years, these three "silent killers" can reduce your real wealth by 50–60% compared to gross projections. Always model your net-of-everything returns.
Benchmark Comparison: Are You Actually Creating Alpha?
If your active investment strategy returns 8%/year while a passive S&P 500 index fund returns 10%, you're not just leaving money on the table — you're likely taking on more risk for less return. True alpha (outperformance above risk-adjusted benchmark) is remarkably rare even among professional fund managers. Use the benchmark comparison to keep yourself honest.
The Time-in-Market Advantage
Compounding rewards patience exponentially. At 10%/year, $10,000 grows to $25k in 10 years, $67k in 20 years, and $174k in 30 years. The last decade adds more absolute dollars than the first two decades combined. Starting earlier — even with smaller amounts — consistently beats waiting to invest larger sums later. The Wealth Projector's milestone table makes this concrete by showing exactly when you'll reach your goals.