As investors, we have been taught that ROI is the measure to look for when investing. It is what defines our successes and failures when we invest, and what influences us to choose a particular investment or fund to begin with.
After all, it seems to make sense. If you measure the amount of money you’ve generated against the amount of capital that you’ve invested, you should get an accurate depiction of how well your money has performed, and how much closer you are to reaching the price tag to your financial freedom.
While this logic may seem sound, there is an emerging school of thought that ROI may no longer be seen as an effective nor efficient way to measure the growth of your money.
What is ROI based investing?
In ROI based investing, people seek to increase, manage and measure the ROI of their investments. The basic assumption is that if all their investments hit their target ROI, their overall wealth – or more specifically net worth – will grow.
Why is this logic flawed?
To understand why the logic of ROI based investing is flawed, we need to get back to the basic question: Why do we invest our money in the first place?
We invest because we want to grow our money to fund our various financial goals. The more money we have, the easier it is to achieve our financial goals. In short, we invest to grow our money, or more specifically, our net worth.
There are two major flaws of ROI based investing:
Let me share with you a story of an extreme ROI investor, Ben (not his real name). Ben is an investor who by his own admission, is driven by the thrill of getting a return on his investment. He feels ecstatic when his investments give him a good return.
Over the years, Ben has invested in a total of five investments – three of which had a positive ROI, while two gave him negative returns. Despite the ‘smaller’ setback, by Ben’s logic, it was still a cause for celebration due to the fact that three out of five of his investments ended up winners.
Ben’s investing style is not unique to any seasoned investors out there. The reality is, when we invest, only some investments will give us our targeted return – others will not go the same way. Some may even have the high probability of losing part of, if not all of your capital. I’m sure many of us can relate to this.
Ben was ecstatic for being able to achieve 3 double-digit ROI out of 5 investments. In his mind’s eye, he was successful in investing and was perfectly happy to continue doing so. But, therein lies the short-sightedness of investors like Ben – many are happy to stop short at attaining an ROI for their investment. They do not delve further to measure and compare the impact of investing to their total wealth.
By choosing only to recognise the wins, Ben has failed to look at the overall impact of his investments to his net worth. In reality, the gains he achieved did little to grow his net worth because the amount of each investment is only RM30,000. As a matter of fact his net worth suffered a setback as a whole due to the quantum of losses from the other two investments which had a capital placement of RM200,000 each. Net to net, the loss outweighed the gains and his net worth suffered a RM6500 hit.
|Net Gain/Lost to Net worth||(6500)|
The moral of the story here is, if you continue to use ROI as your KPI, you are really only growing your net worth in silo. Without adding it up, you won’t know if your net worth actually increases or dropped in value.
So, while it is important to measure ROI, it is even more important to measure the growth of your net worth.
Besides ROI, there are other factors that would affect the growth of your net worth.
In an extreme case, you may have made good gains on your investments only to realise that your total wealth has taken a great hit due to currency depreciation, such as our current predicament where the Ringgit has been devalued by 18% on a year-to-date basis.
How much would this affect an ROI based investor? Sadly the answer is – a lot.
Say for example, Investor A had invested RM 1million and managed to achieve an ROI of 8%. The gains from this investment is quickly offset by the impact of the currency devaluation. From a US Dollar point of view, Investor A would have shrunk his net worth by 10% despite getting a positive ROI for his investment.
The effects of the weakening Ringgit has a widespread effect on a person’s net worth, because one’s purchasing power would have taken a hit from the rising cost of living, more so if you have a penchant for imported goods.
Therefore, if you only pay attention to ROI when you invest, you are not managing all the factors that affect your net worth growth effectively. You are missing out on the big picture of your overall effort to grow net worth.
Net worth based investing: The new way to invest
The correct method of investing is to shift your focus to the growth of your net worth instead of ROI. We call this net worth based investing.
What is Net Worth based Investing?
Net Worth based investing executes investment decisions with net worth growth in mind. It seeks to increase, manage and measure the net worth growth. The basic assumption is that in addition to ROI, there are many factors that would affect net worth growth. To effectively grow net worth, one needs to identify and manage all the factors that will affect net worth growth.
The key to net worth based investing is to look at every factor as a whole, instead of in isolation. In that respect, net worth investing is comprehensive.
In addition to ROI and investment risks, net worth based investing looks at another 7 areas of personal finance to minimise risks and optimise net worth growth:
You must not look at each of these factors in isolation. Net worth based investing manages each factors by taking into account how it will influence and affect other factors.
To use an example, you should not invest into high-risk unregulated investments to maximize your ROI without taking into consideration the risk of losing your capital. Similarly, you cannot continue to invest in more properties without considering its implication on your ability to repay the loans.
Net worth based investing is designed to support your important life goals, such as your children’s higher education, a dream home, perhaps a comfortable retirement plan or your family’s financial security. As such, it requires you to invest your money in consideration of the cash flow requirement of various financial goals.
By using net worth based investing, you essentially begin with the end goal in mind – to focus your efforts and attention to grow your net worth with a direct approach, while focusing on the big picture and not a fraction of the picture.
In doing so, instead of being anxious, confused and stressed, you will be confident, clear-minded and calm having already identified and made aware of all factors that affect your net worth in the long run.
While ROI is an important measure to determine if your investment is performing well, it is not an effective way to measure your success as an investor. It leaves one too drowned in detail to notice the big picture, just as the saying goes, how one can’t see the forest for the trees.
So, don’t get caught up in the obsession over your ROI. Ultimately, your net worth is your true indicator towards your financial freedom.
Yap Ming Hui (email@example.com) is a bestselling author, TV personality, columnist and coach on money optimisation. He heads Whitman Independent Advisors, a licensed independent financial advisory firm which has helped people to optimise their wealth and achieve financial freedom since 2000. For more information, please visit his website at www.whitman.com.my
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