While investors have different notions of what's good and bad -- one investor may be interested in capital preservation and the other capital appreciation -- in general, a good investment is one that makes a decent return. What's more, that level of return should be proportional to the level of risk involved with the investment. That is, you may be willing to take a larger risk for an investment that promises a greater return. Return on investment is used to compare investments with similar risk profiles.
Determine your goals. Do you want to focus on making more money or keeping the money you have? If you want to focus on making money, you need to decide on the amount of risk you are willing to take on because return is a function of risk. For example, if you have an inheritance and want to make sure it's safe while earning a modest income, you may want to focus on low-risk, low-return investments.
Estimate the cash flows from the investment. Investments are compared in terms of cash flows over a certain period of time. If you make more cash than you invest, the investment is good. Say you are comparing two investments. Both investments cost $1,000. The first one is expected to grow to $1,050 after three years. The second one is expected to grow to $1,400 after three years.
Calculate the returns on investment for both prospects. ROI is calculated by dividing profits by costs. The first investment made a profit of $50 from a $1,000 investment. The ROI is $50 divided by $1,000, or 5 percent. Then calculate the ROI of the second investment. The second investment made a profit of $400. The ROI is calculated by dividing $400 by $1,000 or 40 percent.
Compare ROIs. In general, the investment with the higher ROI is the better investment. In this case, the investment with an ROI of 40 percent is better than an investment with an ROI of 5 percent. However, the investment with the higher return might be more risky, whereas the investment with the lower return might be virtually risk-free. If you are more interested in capital preservation, the better investment is the one paying 5 percent.
- Siri Stafford/Digital Vision/Getty Images