How to Think About ROI as an Alt Investor
For an investor, one of the most important success metrics in your toolkit is return on investment. It’s also one of the most useful metrics available, since it allows you to assess the relative success of an investment.
Unfortunately for alternative investors, many ROI calculations are skewed toward conventional investment vehicles (stocks, bonds, and cash). That’s perfectly fine if you’re calculating conventional assets, but with complex alternative investments whose return structure isn’t as clear-cut, it’s not terribly useful.
Here’s a look at the basics of ROI, alternative investments, and a few ways to get started measuring ROI for alternative investments. Keep in mind that our discussion is limited to basic ROI calculations and ways to get started calculating less-than-simple returns, since alternative investments are highly unique.
What is ROI?
Return on investment, or ROI, is commonly bandied about without a full understanding of what it entails. In technical terms, ROI is a performance metric used for one of two things:
- Evaluating returns of an investment
- Evaluating the relative efficiency of an investment, either alone or in comparison to other vehicles
In plain English, it measures the profitability of an investment relative to the cost—how much money you get back relative to how much money you put in. Think of it a little like a profit margin, but for investments. For example, you might use it to evaluate a real estate transaction or measure the profitability of a stock.
This is important to understand because it allows you to see not just whether an investment earns money, but whether the amount of money you get back is worth it relative to the amount of money you put in.
Common ROI Formulas
Here’s the good news: basic ROI is pretty easy to calculate. There are a lot of formulas out there, but you’ll usually see these three.
The first method is the simplest. The formula looks like this:
ROI = (Net Return on Investment / Cost of Investment) x 100%
The second method is a version of the first. The formula looks like this:
ROI = ((Current Value of Investment – Cost of Investment) / Cost of Investment) x 100%
You may also see “current value” written as “gains from investment”.
The third version focuses on the value of the investment, written as follows:
ROI = ((Final Value of Investment – Initial Value of Investment) / Cost of Investment) x 100%
The final result is typically expressed as a percentage, since most people understand percentages more easily than a ratio. That’s why we multiply by 100%. The net result is included in the numerator since returns can be positive or negative. If you get a positive figure, your returns are in the black (total returns exceed total costs). If you get a negative figure, your returns are in the red (total costs exceed total returns).
If you’re paying attention, you’ll notice a key omission from the standard ROI formulas: they do not account for how long an investment is held. They only show your returns as a snapshot, not a rate of return over time.
Let’s say you have an investment that generates 50% return over five years. A simple annual average ROI of 10% (dividing 50% over five years) is only a rough approximation. It completely ignores compounding, which is increasingly prevalent over longer periods—the longer the time period, the greater the effect of compounding.
Annualized ROI accounts for this problem. The formula looks like this:
Annualized ROI=[(1+ROI)1/n−1] × 100%
Where n is the number of years an investment is held. If you plugged in 50% ROI over five years, this would give you an annualized return of 8.45%.
ROI Alternative Investments
This brings us to alternative investments—and where alternative investments diverge from conventional assets.
Alternative investments are inherently more complex than their conventional cousins, especially when it comes to ROI calculations. This is in part because valuation is far more difficult. And because alternative investments are often highly unique, it can be difficult to generalize what a good ROI would look like. Even the returns mechanisms are more complex than conventional assets, since the markets are niche and the assets themselves tend toward illiquidity.
That said, calculating ROI isn’t impossible. You just have to adjust your frame of reference. Here are two things to keep in mind.
Pay Attention to Unique Characteristics
First, pay careful attention to the unique characteristics of the investment in question—particularly how it generates returns over time.
Take a blue-chip painting, for example. Like a stock, you don’t earn money on it until you make a sale. However, you hold a painting for much longer than a stock to ensure it accrues value. Stocks may be bought and sold within the span of a minute, but a painting might commonly be held anywhere from three to ten years.
You also have to pay attention to how the asset accumulates value, especially in cases like blue-chip art where you don’t earn money until you make a sale after a long holding period. In the case of blue-chip art, that means paying careful attention to art market indicators. For example, if an artist has a major museum show two years after you buy a painting and the show is a runaway success, driving demand for the artist’s work, your painting will likely go up in value, especially if the painting in question is typical of the work that was popular in the show.
Calculate Based on Return Type
Once you note the unique characteristics, you can adjust your returns calculations accordingly. The smartest way to do this is to calculate based on the return type. There are three common ways to measure investment returns:
- Cash-on-cash returns
- Simple interest return
- Internal rate of return (IRR)
Cash-on-cash is a money-in-money-back calculation that doesn’t allow for the amount of time the investment was held. Think of it as the basic ROI formula.
Simple interest return, or geometric average, is basically the amount you gained as a percentage of the amount you invested. To calculate it, take the total investment income over the life of the investment, divide it by the principal invested, and then divide the result by the total investment term (either years or a fraction of years). This gives you an annualized percentage rate and is most useful for calculating returns over a short period.
Internal rate of return (IRR) is the annual growth rate an investment is expected to generate. Or, in simple terms, it’s a way to contrast what you might get in the future versus doing nothing, and it allows you to account for timing.
The formula looks like this:
0 = Net Present Value = ((t = 1)∑T) (Ct / (1+IRR)t) – C0
Where t is the number of time periods, Ct is net cash flow during the time period, C0 is the total initial investment costs, and IRR is the internal rate of return.
Making Alternative Investments Work for Your Portfolio
Is your head spinning yet? For average investors, keep the basics in mind: watch the unique characteristics, investigate how your investments will generate returns, select the appropriate calculations, and be sure to consult expert assistance.
That’s where we come in. Here at Masterworks, we’re on a mission to make blue-chip art investing accessible to regular investors like you. We handle the research for you (with some help from our partners at Citi Bank and Bank of America) to identify high-growth artist markets with the best potential risk-adjusted returns. Then, once we authenticate the art, you can purchase shares in the artwork and collect your dividends when we make a sale, usually in three to five years but no more than ten. Sound good? Then fill out your membership application today to learn more.