So Many Shoes, So Little Money – Blog

Return on Investment

June 24th, 2009

I am thrilled to announce I will be on the radio discussing my new book. Please check my website (www.somanyshoes.net) for updated dates and times.

In the meantime, let’s discuss investing. Why should you think about investing your money? Why not just put it into a checking or savings account and let it sit there? Because investments offer a way for you to increase the money you invest by paying you a return.

One way to describe how fast your money is growing (or the increase in the value of your money), is through a concept called return on investment (ROI), a measurement of how efficiently your money is working for you. It is usually expressed as a percentage. It is an important concept to understand because ROI tells you how much your money will grow. Here is the formula for calculating your return on your investment: The gain from the investment minus the cost of the investment, divided by the cost of the investment
Note that while it is a math formula, it only uses subtraction and division. Let’s look at two examples.

Example one: you put 1,000 dollars into your savings account at the beginning of a year. The bank paid you interest on your money. Let’s assume you left the 1,000 dollars in there for the entire year and, at the end of the year, you check your savings account balance and see that you have 1,020 dollars. What was your return on investment? Your return on investment was 2%:

1,020 dollars minus 1,000 dollars equals twenty dollars.
Twenty dollars divided by 1,000 dollars equals 2%.

Example two: let’s assume you put 2,500 dollars into your savings account at the beginning of a year. You leave the 2,500 dollars in there for the entire year and, at the end of the year, you check your savings account balance and see that you now have 2,600 dollars. What was your return on investment? Your return on investment was 4%:

600 dollars minus 2,500 dollars equals 100 dollars.
One hundred dollars divided by 2,500 dollars equals 4%.

As you can see, in both cases you earned money, but the amount of money you earned was small. Your money earned money, but it could have earned more than it did. You work hard for your money and your money can work harder for you.

In a checking or savings account, your return on investment comes solely from the interest the bank pays you which are typically, fairly low amounts. However, in addition to checking and savings accounts, banks offer other kinds of accounts which pay higher interest.

One type of investment account that banks offer is called a certificate of deposit (CD for short). A CD is a special type of savings account and is a great place for a beginning investor to start investing their money. A CD differs from both a savings account and checking accounts because your money goes into a CD for a specific, fixed period of time (often three months, six months, or one to five years). During the period of time that you sign up for, you really don’t have access to your money. (In a regular checking or savings account, you can withdraw your money at any time you need to.) In a CD, if you pull your money out early, there’s a penalty fee. However, in return for leaving your money in the bank for so long, the bank pays you a higher interest rate than they pay on a checking or savings account. Once the period of time that you selected ends, you get back all of your money plus the interest your money earned for you. Then you can decide if you want to re-invest your money in another CD, selecting perhaps a different time period, or put it back into your checking or savings account.

Why is a CD a great place for a beginning investor to start? Because a CD pays a higher rate of interest than a checking or savings account and so you receive a higher rate of return (ROI) on your money. But because you can’t take your money out early without incurring penalties, you learn whether you have the tolerance to keep money tied up for some period of time. A CD is a way to check if you will miss having access to your money, without the risk of losing any of it. A CD is federally insured against losses, and allows you to begin to understand your personal risk tolerance.

More about personal risk tolerance and other kinds in investments in posts to follow.

Filed under: Investing

Tags: Investing