Shared Knowledge

"Investing - Return on Investment (ROI)"

14 January 2011



Summary: in evaluating investment portfolio holdings for purposes of  determining if sell, add-to or hold is in order, nothing is more important than using accurate return-on-investment (ROI) information. Determining the ROI of a stock or mutual fund ranges from being simple to quite complex depending on the number of investment transactions a specific stock or mutual fund has.




I am an investor with more than 30 years experience in stocks, bonds and mutual funds.

I am not a profession investment manager.

I did all the right things to get into investing by reading scores of books on the subject, attending lectures and talking with brokers. I also regularly read the Wall Street Journal and other money oriented magazines.

Over the course of time, I built a portfolio of over 190 unique investments. I thought I was fairly smart in my stock and mutual fund selection and for a while, simply recorded any interest, dividends and capital gains my investments distributed to me one or more times a year.

But when I would review my portfolio ever quarter or so, my gut would tell me that some investments were way up from where I bought them and others way down. But how to objectively determine which investments I should sell, add-to or simply hold?

I needed accurate return-on-investment (ROI) information on each of my holdings.



Before defining what ROI is, some definitions are in order:

- Cost basis. When you buy an investment, be it a single stock or shares in a mutual fund or a bond, what you paid for the investment is your base cost basis in that investment.

- Investment income. If an investment kicks off any type of actual money return, this is investment income. For bonds, this income is interest. For stocks, you might receive a dividend and for mutual funds, you might receive dividends and short and long term capital gains distributions.

- Realized capital gains. When you sell or otherwise dispose of an investment, the difference between the investment's cost basis and sales proceeds, minus any sort of sales charges, is realized capital gains or losses.

- Unrealized capital gains. The difference between the cost basis of an investment and its current worth. Here, a sale is not involved.

- Cost Basis to include reinvested dividends and short and long term capital gains distributions. When you have dividends and short and long term capital gains distributions automatically converted into additional shares of stock or a mutual fund, the amount of distribution increases your cost basis in that stock or mutual fund.

- Pre-tax ROI. ROI calculated without regard to the impact of income taxes on any income received and realized or unrealized capital gains.

- Post-tax ROI. ROI after the impact of income taxes is factored into realized and unrealized capital gains and all investment income. If you are in a high income tax bracket, the impact of taxes on your ROI can be significant and as suggested by many authorities, you should consider the advantages of investments that offer tax-free income.


What is return-on-investment (ROI)?

ROI $'s (pre-tax) = (realized capital gains + unrealized capital gains + dividends + short and long term capital gains distributions) - Cost basis (purchase price of investment + reinvested dividends + reinvested short and long term capital gains distributions).

ROI $ (post-tax) = ((realized capital gains - income tax actually paid on gains) + (unrealized capital gains - income tax that would have to be paid at actual sale) + (dividends received - income tax that had to be paid when received) + (reinvested short and long term capital gains - income tax actually paid when received) - Cost basis (purchase price of investment + reinvested dividends + reinvested long and short term capital gains).

ROI % total = ROI $'s\cost basis $'s

ROI % average annual = (ROI $'s\cost basis $'s)\# years investment held. ROI % average annual is only a very rough measure because it assumes that all dollars invested were invested on the first day the investment was first acquired and does not take into account the shorter holding period of additional purchases or of reinvested dividends and short and long term capital gains distributions. True average annual ROI% would be very difficult to calculate on an investment held for many years with multiple purchases and reinvested dividends.



1.I "buy" a certificate of deposit (CD) for $1000 and receive 2% interest on it yearly, or $20. My pre-tax ROI is 2%.  Now because I have to pay Federal and state income taxes, my $20 must be reduced by the income taxes. In my case, since I have to pay 15% on every taxed dollar, $20 x .85 = $17 for a post-tax ROI of 1.7%.

2. I buy a municipal bond having a face value of $5000 for $5000 or what is known as "par" that pays 5% ($250) Federal and Virginia state income tax free interest per year. As I pay no income tax on interest received, my pre and post-tax ROI are the same or 5%. NO, not really. Unlike a CD, bond valves move up or down depending on current municipal bond interest rates. So when I look at determining ROI for this bond I find that although I paid $5000 for it, it is only currently worth $4800. Now ROI $'s = unrealized capital gain ($4800 - $5000) + $250 of interest received = $50 ROI or $50\$5000 = 1% pre and post tax ROI %. Not so good. Luckily I do not have to sell the bond and continue to receive $250 per year for 5 years. At the end of the 5 year period, the bond is still worth only $4800 but my total ROI$ =  -$200 unrealized capital gains + $250x5 = $-200 + $1250 = $1050 for a ROI % total of $1050\$5000 = 21% but this % is for 5 years, so average annual is  21%\5 = 4.2%.

3.I buy 1000 shares of XXX company for $1000 or $1 per share on the first day of the year. I do not add to your position during the year but at year's end find out that my shares are now worth $1.30 a share and I sell. I net $1300 from the sale. Realized capital gains - cost basis = $1300 - $1000 = $300 ROI or $300/$1000 = 30% ROI. Now since I owned the stock for only one year, my average annual ROI % is 30%. But all this is pre-tax. Considering income taxes, because I pay 20% on capital gains, I must reduce my ROI $'s such that I am actually only keeping $300 x .8 or $240. Now my post-tax ROI gain is $240 or $240\$1000 = 24%. Since the example had a one year holding period, the average annual post-tax ROI % = 24%. Not bad.

4. I buy 1000 shares of XXX mutual fund on 1 January 2011 for $1000 and have all distributed dividends and long and short term capital gains reinvested in more shares. At the end of the of the year, I learn that the current share price is $1.08. Counting dividend shares and reinvested long term capital gains shares received, I have 1010 shares. @ $1.08 per share X 1010  if I were to sell I would receive = $1098.80. But what did I invest? $1000 + the costs of reinvested dividends and long term capital gains. The cost of these were $1.11 a share for a total of $11.10 so my total investment was $1011.10. So my unrealized capital gains is $1099.80 - cost basis of $1011.10 = $88.70. $88.70/$1011.10 = 8.7% but wait, need to add in the $11.10 of dividends and capital gains received so total pre-tax return is not $88.70 but rather $88.70+11.10 = $99.80 or $99.80/$1011.10 = 9.8%. Again, not a difficult calculation to make to get a ball park ROI but in this example, all money invested was assumed to have been invested on day one. The fact that reinvested dividends and capital gain distributions where made only a month before the end of the year was not considered in ROI in any way. And all above is pre-tax. And what does post-tax look like? Again, if I were to sell all shares, I would net $1099.80 but since I only get to keep 80% of any gain after paying 20% in capital gains tax, my real net on the sale is ($1099.80 - $1011.10) x .8 = $70.96. And then I can add in reinvested dividends and capital gains distributions but I also have to pay income tax on these forms of income. I pay 15% on every dividend and capital gains distribution dollar received so although I received $11.10, after taxes, I actually only received $11.10x.85 = $9.44. Now my post tax net is $70.96 + 9.44 = $80.40. $80.40\$1011.10 = post-tax ROI % = 7.95%. Still not a bad ROI% but less than pre-tax.

5.Using the mutual fund example above, supposed I hold the mutual fund for 10 years, all the while reinvesting dividends and capital gains distributions. As you can imagine, determining ROI can be quite time consuming and in the end, the average annual ROI%, either pre or post tax is only an approximation because of the difficulty of factoring in the time period each investment acquire held.


Why you can not trust published sources of ROI

Want to know the ROI for a mutual fund you own? No problem, you simply look up published data for the fund. Well, not exactly. Be aware that mutual funds determine their annual ROI % by phantom investing a fixed amount on the first day of the year and then reinvesting all dividends and capital gains distributions. In their calculation of return, they never add another dollar to the investment during the year beyond the initial, day 1, buy. So, if you buy a fund on 1 January of a year and never add to it during the year, the published ROI are more or less accurate for you, pre-tax. However, if you bought shares in a prior year, current year published data means nothing to you as prior year investments are not included.

Ok, so if daily, published, mutual fund ROI information is only accurate for a very specific situation, how about fund historical data showing 1, 5 or longer period results? Again, these results are based upon a very unreal specific situation. For the 3 year average, money is assumed to have been invested on the first day of the defined period and never added to and all distributed dividends and capital gains are reinvested. And to beat a dead horse but all data is pre-tax.


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