A lot of people who have begun work on increasing their financial stability and bringing additional revenue streams on board will be familiar with the concept of return on investment (ROI). This practice is well-established among investors and entrepreneurs who use it as a tool to quantify profitability. However, as ROI has entered the mainstream, people increasingly seek to apply it to decisions in their personal lives; in doing so, they may encounter limitations or make mistakes. Here’s what you can do to avoid such pitfalls in your decision-making.
Account for all expenses
When you shell out money on a significant purchase, it’s rarely a simple one-step transaction. For example, buying a house typically entails taking out a loan, covering agent fees and taxes, and paying for upkeep in the form of insurance, repair, and association dues. Not only does it get hard to keep track of such additional costs, but many of them are also recurring. Thus, further constraints may be applied to your monthly budget, which can give rise to opportunity costs. If you’ve committed a set amount of money to pay for a mortgage and other related expenses each month, it can limit your ability to invest in other assets that appreciate, such as shares of stock. The bottom line is that all of these added expenses can be difficult to anticipate; thus, ROI can be limited or even misleading without proper planning.
ROI is not cash
One of the biggest mistakes a business owner can make when using ROI in their decisions is to confuse profits with cash. For businesses, cash flow is critical; you always pay upfront costs with cash, but profitability is subject to future costs and deductions. On a personal level, a similar pitfall can await anyone seeking to analyze a potential investment opportunity with ROI computations. For example, if you were to buy shares of stock and sell them later on for a profit, you may also have to pay capital gains tax and thus net a lower return than expected. Furthermore, ROI technically isn’t money in the bank. If you need the money for an emergency, you can’t merely sell assets on short notice and expect to realize those projected returns.
Not everything is an investment
Investment decisions can be complicated and deserve all the consideration you can spare. However, framing every asset as an investment is also a means of simplifying one’s thought process. Taken too far, you can end up ignoring other intangible properties or values. For instance, in-ground swimming pools are considered to be a solid opportunity to add value to your property. But most homeowners derive a lot of enjoyment from the swimming area as a source of recreation and a venue for entertaining family and guests. Similarly, cars are known to be a type of asset that only depreciates over time, but people buy them anyway and even spend on upgrades, which won’t yield any returns. By focusing too much on ROI, you can ignore the human element and utility value of an asset, which may even be more significant than the numbers on the balance sheet.
Calculating ROI is a great practice that can help you understand the value of purchase better, but it’s also just a tool. It doesn’t solve everything, and mistakes can be made in its application. Used judiciously, as part of a diverse strategic approach, ROI can, indeed, improve your decision-making in your personal life.