Step 1
Step 3
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.
Step 2
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.
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.
Step 4
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.
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