5 >   Measure and Choose With ROI

For a few months after moving into that old Main Street building, my single employee and I spent our workdays at our folding table desks by the front door. We continued to create and sell software plugins to the user base I had stumbled upon. Sales were strong, margins were high, and overhead was low. That combination meant profits were high, too.

Though my lifestyle was below middle class, I wasn’t about to consume these newfound profits. My wife and I continued to drive 10-year-old cars, and put elbow grease into projects like replacing plaster with drywall in our 100-year-old house. I was quite happy with my lifestyle and didn’t feel any urge to change it. I was really happy building my business and enjoying my work. I didn’t feel deprived. I did accumulate cash in savings.

This raised a question: what to do with that savings? To begin, I calculated how much we’d need to set aside each year to cover our retirement. We were in our 20s, so we didn’t need to save much per year to cover our future needs. The growth we could expect in our savings over time meant the annual contribution required would be small. We put that amount (a few thousand dollars) into S&P 500 index funds in Roth IRA accounts. This left a lot of savings available to do something else with.

I didn’t have any good ideas for what to invest that savings in. I knew I could put it in the general stock market and make a modest return over time. That sounded kind of boring to me, and I wanted to do more with my newfound enjoyment of building my own business. I had conviction I could make higher returns in business than in the stock market.

I wasn’t rich at that time, not even close. Because I was limiting my consumption, I didn’t need to be rich to have an investable surplus. I already had a “what to invest extra money in” problem.

I’ve never found much sympathy for this challenge from anyone, and you probably won’t, either. As my resources have grown and the challenge of investing them well has also gotten bigger, the sympathy seems to get even smaller. Nonetheless, it is a very real challenge for investment-minded people to decide the best thing to do with investable resources. It’s not easy to find superior investment opportunities. When you feel this challenge, instead of the challenge to come up with some investable resources, consider it a good sign.

Besides lacking investment ideas, I had another problem: I saw a lot of risk in the software business I had built. All of our customers were users of the same software package. We didn’t produce or sell that software. We sold add-ons to it. If that software package was taken off the market, bought by a competitor, or otherwise affected by a big change, we could be out of business very quickly. The narrow niche we served made for easy entry and an obvious path to marketing. It also made our entire business vulnerable to any changes affecting that niche. I didn’t like that. I am prone to excessive worry about downside scenarios. Having an employee depending on the stability of the business to pay his mortgage and feed his family added a new sense of weight to my paranoia. I wanted a backup plan, and I didn’t have one.

During those months of head scratching and software selling, Phil (that first employee) and I decided to setup a recording studio. We both had gone to college for audio-visual production. He graduated, I dropped out, and we both remained interested in audio and video. We figured we’d use all that office space not occupied by our two desks for our studio.

I felt silly spending money to set up a recording studio in a town of 800 people. There would be little to no demand for recording services in our area. If that wasn’t problem enough, I knew the recording studio business was facing big challenges from the decreasing cost and increasing quality of home recording. I distinctly remember telling Phil, “We’ll never make any money on this recording studio.” I was right about that, but it turned out to be a worthwhile project for other reasons.

I didn’t see the recording studio as a solution to my need for investment opportunities. I didn’t spend much money on it—certainly not the money I was looking to invest. Luckily, by exploring this hobby interest, I stumbled upon a good investment opportunity.

We wanted to ensure our studio produced recordings with quality sound. That meant we’d need to ensure the acoustics of the room were top-notch. I found acoustical engineering information online, and planned the acoustical treatments for the studio. We’d need wall panels to reduce echo, soundproof coverings for the windows, and a few other things.

A little price shopping quickly revealed that buying those treatments would cost much more than I wanted to pay. I was shocked at how expensive they were. So I decided to build my own. More online research gave me the info I needed to do that, but I found it difficult to source the materials I’d need. At that time, the only way to get those specialty acoustical materials was to find a building contractor who could special order them from the manufacturers. That’s what I did. The materials came in inconveniently large bundle quantities, with expensive shipping via truck freight.

After the material arrived, I came into the office on a Saturday and built the acoustical treatments for our studio. Sawdust and fabric clippings littered the floor of our software office–turned–recording studio. The acoustical product designs were mine, the costs were low, and I was happy with how the studio looked and sounded.

I had a lot of materials left over. I sat with my legs dangling off a big bale of rockwool batts, and admired my handiwork. It still didn’t make sense to me that anything should be so hard to source. We had Google and Amazon for finding and buying things. It should be as easy as a few clicks to get those materials. I couldn’t think of anything stopping me from making it that way. In the weeks that followed I started ATS Acoustics, an online store selling specialty acoustical materials with easy shipping via FedEx Ground.

I wasn’t about to risk much money on an untested business idea. I used some resources I already had including the suppliers I’d found, my experience in e-commerce Website development, my experience in audio engineering, and the office space we occupied. These resources wouldn’t show up on a financial statement or a loan application. I didn’t have any credentials or degrees in these skills, but they were what I needed. I had enough to get started. I don’t remember spending any money at the beginning except $10 to register the domain name atsacoustics.com. My leftover materials were the inventory we started with.

I was thinking about the likely returns on anything I put at risk during this untested, startup phase. The first return I wanted was a learning outcome, to find out if this business would get traction with customers. I wanted to use the smallest amount of resources that would get that done.

I was really scared. Scared that people would laugh at me if it didn’t work out. Scared that I didn’t have the skills or the confidence to pull this off. Scared that people wouldn’t understand what made me set off in this random new direction. Scared as I was, I went forward.

Fortunately that business idea worked out well. People did buy acoustical materials from our online store, and some of them wanted to buy the finished products I’d made, as pictured on our Website. I figured we made them once, so we could make them again. I hired an additional employee to help, and there in the studio and software office, we built acoustic treatments to fill those first few orders.

The software business was called Aardsma Technology Services—ATS for short. We named the new business ATS Acoustics because we shared the same office and phone lines. When customers called we didn’t know if they wanted software or acoustic panels, so we just answered the phone “ATS. How can I help you?” every time.

It was a little ridiculous really. We had to wave frantically to each other to turn off the noisy power tools when the phone was ringing with a customer on the line. Our studio was covered in sawdust and fabric clippings on a daily basis. (As expected, we weren’t in demand to record any bands in there.) We used the space, people, skills, and materials we had to test the return on that business before I took much financial risk on it.

It tested well, and I turned on the spigot. Over the next several years I invested nearly all of my work time and available money into growing that business. As customers placed orders and our accounting showed monthly profits, that gave me plenty of evidence that the risk was lower and the return on investment dramatically higher than what I could get anywhere else. I wasn’t about to hold back from investing in a high-return opportunity like that.

ATS Acoustics grew little by little into a substantial business. Opportunism and some luck, combined with the resources we had, led to great results. My return on investment so far on ATS Acoustics is a few hundred times greater than what I would likely have received if I had invested my time writing more software and my savings in the stock market.

At no time during any of that did I have a clear master plan. I was making decisions as I went along, with dreadfully poor ability to predict the future. Luck and happenstance played a role. At the same time, I was thinking about risk and return, and doing my best to make rational investment decisions with my resources.

Allocate Your Resources Based on Risk and Return

Investment is trading part of your resources for something that contributes to a future increase in your resources. Something that provides a return. Your resources are always limited. There will always be more investment opportunity than you have resources to invest. This is true of time, money, and every other resource.

Nobody has enough money to buy a big chunk of stock in every large company in the world. Nobody has enough time to study every major in college, learn every rewarding hobby, or serve every good cause. Even billionaires and people who live to be more than 100 years old run short of money and time way before they run out of opportunities to use them.

I took my young daughter to a big candy store, and gave her some money to spend on one kind of candy. This place had aisles of licorice and lollipops, chocolates and jelly beans, and much more. She walked through the store, visually scanning hundreds of choices, some mouth-watering favorites, and some she scrunched up her face at and said, “Blech.” Though she was only 5 years old, she found a way to sort and prioritize all those options, and pick the one she’d enjoy most. In doing that, she said no to every other candy option, so she could spend her limited money on her top choice.

Your job as an investor is very much like this. You must sort and prioritize your investment opportunities, say no to nearly all of them, and allocate your limited resources to the very best of them. Later on, as returns come in and your resources grow, you head back to the “candy store” and repeat the process of choosing the best opportunity from what’s available at that time.

Flavor and color preferences might be the qualities my daughter used to sort and prioritize all those investment options. Risk and return are the qualities you’ll use to sort and prioritize your investment opportunities. You need a clear understanding of the likely return, and the risk involved, in every investment opportunity you consider. Armed with this information, you can compare one opportunity to another with relative objectivity.

The Investor’s Task

Take the resources available to you

and invest them where you will get

the best return available to you.

Use ROI to Evaluate and Compare Investments

In order to compare one investment to another, you need an apples-to-apples comparison of the return from each. Return on investment (ROI) is typically stated in percent return per year, and provides that standardized comparison.

(Return per Year / Amount Invested) × 100

= Percent Return on Investment (ROI)

Many investments lend themselves to direct measurement of the return, in specific dollar amounts. For example, if you buy $10,000 of stock in Company A and receive an increase in value of $500 per year:

(500 increase in value / 10,000 invested) × 100 = 5% ROI

If you buy $10,000 of stock in Company B and receive an increase in value of $1,000 per year:

(1,000 / 10,000) × 100 = 10% ROI

Sometimes the return comes in a defined period of time that’s not one year. For example, buying $10,000 of inventory that will sell in three months (0.25 years) at a $3,000 profit doesn’t conveniently match an even-years time frame. We still express the ROI on that investment on a per-year basis, as an annual return. This allows straightforward comparisons between investments with different amounts of time between initial investment and the payback of returns. Everything is stated in percent return per year.

Total Return / Time in Years = Annualized Return

(Annualized Return / Amount Invested) × 100 = ROI%

Our inventory example:

$3,000 return / 0.25 years = $12,000 annualized return

($12,000 / $10,000) × 100 = 120% ROI

Some investments aren’t made in dollars. They might be in time, or they might be in something hard to measure in numbers. Nonetheless the same concept of ROI applies. Estimate the value of what you are investing and the value of what you will get back over time.

Here are some examples of evaluating ROI.

Choosing a Certificate of Deposit Investment

One bank offers to pay 3% interest per year on a certificate of deposit (CD), and another bank offers to pay 4% interest per year on the same kind of certificate of deposit. Because the CDs at both banks are FDIC insured, they both involve virtually no risk of loss. It’s an easy decision to allocate your money to the 4% CD rather than the 3% CD, because the 4% return is higher.

This example is easy because the ROI for each CD is guaranteed by the bank, and calculated and stated for us. In many real-life investment decisions, we must estimate returns and calculate the ROI of each option ourselves.

Deciding Which Class to Take

Resource allocation doesn’t always involve money. If your community college is offering free classes on five different topics, at overlapping time slots, you might have a choice to invest your time in one of them, but not more than one. The classes don’t pay a financial return, at least not directly. They provide knowledge, skills, and perhaps connections to new relationships.

To rationally decide which class to allocate your time to, you’ll need to evaluate the benefits that each class will return in exchange for the time invested. If some classes require a greater time commitment than others, you’ll need to evaluate benefit per hours of time invested, a non-financial form of ROI. The class with the highest benefit per hour would likely be the best investment to allocate your time to.

Benefits like skills and relationships can’t be precisely quantified the way many tangible and financial benefits can. We typically can’t calculate 2.75-percent improvement in relationship per hour, or 6.3 units of additional skill per class taken. Nonetheless, we can make estimates that allow us to compare non-financial returns.

Perhaps you’d look through the class outlines, and count how many job skill requirements each class would fulfill. If you estimate that an advanced class will cover eight skill requirements with 48 hours invested, and the intro class will cover just four skills, for 32 hours invested, you can make a rational decision. The return on the advanced class is one skill per 6 hours, and on the intro class is 1 skill per 8 hours invested. Even when dollars and financial securities are not involved, you can still make estimates and “do the math” to make a rational decision about what offers the best return.

Deciding Which Debt to Pay Down First

If you owe credit card debt charging 20% interest, and a home mortgage charging 4% interest, and you have $1,000 extra dollars this month, which debt should you pay extra on? Paying $1,000 extra on the credit card saves $200 interest per year. Paying $1,000 extra on the home mortgage saves $40 interest per year (probably less due to the home mortgage interest tax deduction). The return on paying down the credit card debt is greater, so that’s the rational choice.

Leasing vs. Buying

A business owner of mine asked about leasing versus buying some computer servers. He expressed a desire to conserve cash and be careful not to spend too much. I agreed with his conservative instinct and suggested we analyze the lease versus buy decision based on the ROI of each option.

As I recall, the terms of the lease were three years at $260 a month to lease a server that sells new for $7,000. At the end of the three-year lease, he had the option to buy the equipment for $1,500 and keep it. The three-year lease is, in effect, a way to borrow $7,000 from the server manufacturer. Here’s how we broke down the ROI.

Total lease payments (36 × $260)	$9,360
Buyout at end of lease.	$1,500
Total cost to acquire 1 server via lease ($9,360 + $1,500)	$10,860
Total cost to acquire 1 server via up-front purchase.	$7,000
Additional cost of lease vs. up-front purchase. ($10,860 – $7,000)	$3,860
Additional cost of lease per year. ($3,860 / 3 years)	$1,287
Effective “interest rate” on the $7,000 borrowed. ($1,287 / $7,000)	18%

That 18% cost means the lease would have a negative 18% ROI. That gave us the number we needed to ask the next question: Did he have access to $7,000 at a cost less than 18% per year? Could he borrow at less than 18% interest per year? Could he sell an investment that’s earning less than 18% per year to buy the servers with cash? He had multiple ways to obtain the cash to buy the servers at a cost much lower than 18% per year.

Sometimes life and business present more complex scenarios that require additional logical and mathematical steps to properly evaluate the ROI. My goal here isn’t to replicate what business textbooks and other resources teach. It’s to emphasize that mathematical evaluation of the return on each investment opportunity enables rational decision-making.

Even if math is not your thing, don’t miss the concept. Lots of investment opportunities compete for your resources. The opportunities offering the highest return, after accounting for risk, should win the competition. Rationally evaluate the ROI of each investment opportunity. Allocate your resources to the opportunities where you expect the highest return.

What’s the Risk of Loss?

All investments involve risk and uncertainty, and thus the future return of any investment cannot be known for sure.

You don’t know for sure what Wal-Mart’s profits will be next year. You don’t know for sure that degree will lead to a high-paying job, those long hours will get you the promotion, or that business you are starting will succeed.

With all investments, there’s a risk you will receive less return than you are expecting. You might lose part of the amount you invested (a negative ROI), or even take a total loss.

Some investments are much riskier than others. You are much less likely to lose money investing in United States Treasury bonds than you are in an untested startup business. Rational investors accept a lower rate of return on lower-risk investments, and require a higher rate of return on higher-risk investments. For example, investors are currently willing to invest in 10-year Treasury bonds for about 2% ROI, and investors typically expect 20% ROI or more when investing in startup companies.

Risk and return are the primary qualities by which you will sort and prioritize your investment opportunities.

Factor Risk Into Expected Return

The concept of expected return allows you to compare the returns of investments with different levels of risk. Here’s a way to calculate that, in a success-of-failure scenario.

(Probability of Success × Return if Success) +

(Probability of Failure × Return if Failure) = Expected Return

For example, an investment in a small pharmaceutical company with one big drug about to break (or fail) might look like this. You might expect a return of 50% if all goes well and the FDA approves the drug and a total loss on the investment if it turns out the drug is unsafe. You estimate the odds of success at 75% and the odds of failure at 25%. You can afford to lose your investment in this obviously risky company. What return can you expect from this investment, taking into account those risks?

We’ll convert percentages to decimals for the math. Here it is:

(0.75 chance of success × 0.50 return if success) +

(0.25 chance of failure * –1.00 return if failure)

     = 0.125 or 12.5% expected return

This math applies to a simple success-or-failure case. It’s suitable for most investment decisions I come across in normal life and business. More complex math applies to situations where there are probabilities of partial success, etc. For most of us in practice, the more complex the math required to analyze the decision, the greater odds of making an irrational decision.

Many times you will need to make reasonable estimates of these risk and return values, using your best judgment of the situation. If someone could tell you the precise risk and precise return in advance, investment decisions would all be no-brainers. The in-depth knowledge to assess risk and return better than others is a big part of what makes a good investor.

Make Sure You Live to Play Another Day

If the risk is high, and the return is low, it should be a no brainer to pass on such an investment “opportunity.”

Additionally, some investments are too risky to justify making, even when the expected return is high.

For example, some venture capital investments in startup businesses offer a risk/return profile something like a 10% chance of a 2,000% return, and a 90% chance of total loss (–100% return). The expected return is 110%.

That’s an excellent return, if you can tolerate the risk. I’d bet a small percentage of my assets on a single investment like that, and I do sometimes. To bet all my assets on a single investment like that would be foolish. Doing so would mean a 10% chance of increasing my assets by 2,000%, and a 90% chance of financial ruin.

Personally, I never want to make a bet I can’t afford to lose. If an investment goes poorly, or completely bust, I always want to have ample resources left to wake up the next day and try again. Sometimes that means passing up an appealing expected return because it would require betting too large a piece of my farm, so to speak.

I’ve made some big bets on my own businesses, but I’ve never found it necessary to bet anything I couldn’t afford to lose. Occasionally life does present the need to go “all in” on a business or investment in an attempt to avoid losing it. Whenever possible, I try to play my cards in a way that doesn’t put me in that undesirable scenario.

All Your Resources Are in the Same Pool

In Chapter 2 we talked about maximizing returns by looking broadly at all kinds of resources we can invest, not just cash. In addition to that, we make better investment decisions when we view all our resources as one pool, rather than splitting them into separate decision compartments.

Consider this example of an investment mistake. In the morning, a fictional investor named Bob looked at his retirement account, and rationally evaluated which stock or bond to invest in. He compared half a dozen alternatives, and chose the investment with the best return. That was a stock that he estimated he could expect a 7% ROI from. He invested $10,000 in it, and took a break for lunch.

In the afternoon, Bob paid his bills. He made the minimum payment on a credit card carrying a $5,000 balance at 14% interest, and paid $1,000 extra on a credit card carrying a $5,000 balance at 20% interest.

Bob made a rational decision about which stock or bond to invest his retirement money in (the best he could find), and a rational decision about which credit card to pay down (the one charging more interest). But by treating the morning’s retirement investment decision as separate from the afternoon’s debt paydown decision, he failed to allocate his resources to his best available return. Assuming no withdrawal penalty or tax consequences, his best available return on the $10,000 he invested in retirement that morning was to pay off both the 20% and the 14% debt. That would save a lot more money than the 7% he’d earn from the stock investment.

When allocating your available resources, there should only be one master list of opportunities, sorted by return. Creating separate groups of opportunities and choosing within them leads to errors like Bob made.

Here’s another example. Say you own two businesses, both with growth potential. You have $10,000 to invest. You determine that your first business will provide a 30% ROI on that $10,000 if you invest it there, and the second business will provide a 15% ROI. Naturally, you’d choose to invest the $10,000 in the first business. Looking at all your resources in one pool goes further than that. If there is additional opportunity to invest in the first business at 30% ROI, do you have any resources earning less than 30% that you can reallocate to the first business? If so, and the risk of loss in the first business is acceptable, it probably makes sense to make that reallocation. If circumstances permit, it might even be rational to sell the second business, and invest the proceeds in the first business.

Alternately, if the first business has all the resources it needs, do you have any resources earning less than 15% that you can reallocate to the second business? Stocks, bonds, savings accounts, or property you could sell?

It’s all one pool. If necessary, reallocate your resources from lower-returning to higher-returning investment opportunities.

It doesn’t make sense to pay 15% interest on a business loan while earning 3% on a CD at the bank. It doesn’t make sense to pass up $30/ hour overtime at work and then spend an hour mowing your own lawn to save $20 (unless you want to pay $10 for an hour of exercise and fresh air).

Sometimes there are risk differences between investment opportunities, tax consequences for moving resources from one investment to another, regulatory restrictions like early withdrawal penalties, or other barriers to reallocating assets. For these reasons, it may not be practical to move resources every time a higher return opportunity becomes available. And diversification probably means you won’t put all your resources on your single highest-returning investment.

Don’t break up your resources into separate compartments unless there are good reasons to do that. Evaluate your investment opportunities all across the board, and when possible, reallocate resources from low-return to high-return opportunities, even if you might normally think of those resources as belonging to two separate parts of your life. Allocate resources between categories, not just within them.

Count Taxes and Inflation When Comparing Financial Returns

Unlike many investments of time and other resources, investments involving money are usually affected by taxes and inflation. The purpose of financial investment is to grow your resources. Your resources grow by the amount that’s left over after taxes and inflation. If you compare returns without adjusting for taxes and inflation, you might make investment mistakes.

For example, if you have a choice between purchasing an investment in your Roth IRA that yields 6%, or loaning money to your friend’s business for 7% interest, you must consider the after-tax returns to make an accurate decision. Investments in a Roth IRA grow tax free, so your 6% return will still be a 6% return after taxes. Interest income on the business loan you made will likely be taxed at ordinary income tax rates, currently up to about 40%. That 40% tax would change your 7% return into a 4.2% after-tax return. All of a sudden putting the money into your Roth IRA doesn’t look so bad. It’s as if some of the candy in the candy store is subject to sales tax, and some isn’t.

Similarly, say I want to attend a seminar for my training and development, and I have two choices, each costing $1,000. One seminar qualifies as a business expense, and one would be a personal expense. The expense for the business seminar would reduce my business income, and thus reduce my taxes. The personal seminar would cost $1,000 after tax, but the business seminar would cost me only about $600 after the $400 reduction in my income tax bill is accounted for.

The type and timing of taxes is also impactful. Currently capital gains taxes on investments aren’t due until the investments are sold. If you hold them for 50 years, you can delay that tax bill for a very long time, and earn additional returns in the meantime on money that would have gone to taxes. Also, currently in the United States, higher tax rates apply to gains on investments held for less than a year than on those held for a year or more. The rules tend to change. Learn how they affect your investment decisions.

Inflation also has an effect. We tend to think of dollars as fixed value things, and that’s adequate for everyday life. When investing and receiving dollars over long times spans, we need to account for the change in their value over time. As is the case with all other resources, the value of currency, including dollars, is variable. Central banks try to maintain a positive rate of inflation of about 2 percent per year, which means the value of a dollar—what you can buy with it—typically goes down about 2 percent per year.

Inflation changes the value of money over time, and that means it affects the return on investments that pay back in dollars after a period of time. Most financial investments fall into this category, and are affected by inflation.

For example, if you invest $10,000 in stocks, and 20 years later sell those stocks for $30,000, your total return before inflation was 200%. If during that time inflation averaged 2% per year, it would take about $1.50 at the end of that 20-year period to buy what $1.00 would buy at the beginning. The real return, after inflation, is 200% divided by 1.5, which equals 133%.

Inflation works against lenders and most other types of investments, but it works in favor of borrowers. When you borrow money in today’s dollars, and pay it back in the future with the future’s dollars, inflation means the dollars you paid back with are worth less than the dollars you borrowed. Part of the interest rate you pay when you borrow money goes to cover inflation, which is not a real cost to you, and not a real profit for the lender. The remaining interest is your true cost of borrowing. For example if you borrow money at 4% interest, and inflation is 2% per year, you true cost of borrowing is 2%, not 4%.

The combined effect of taxes and inflation determine your actual return on investment, and your actual cost of borrowing. Under current rules, home mortgage interest and interest expense within a business are typically tax deductible. If my interest rate is 4%, my marginal tax rate (including state taxes) is 50%, and inflation is 2%, my true cost for borrowing money through my home mortgage is 0 (4% interest × 50% tax savings = 2% minus 2% inflation = 0%). The 50% tax savings reduces my rate to 2%, and 2% inflation reduces the real rate I’m paying to 0.

Just as inflation reduces the real cost of borrowing, it also reduces the real return on lending. When you receive interest on a bond, or an increase in the dollar value of a stock, your real return, the increase in purchasing power of your resources, is after inflation.

Again, I won’t try to replicate the in-depth study of these topics made in textbooks and online learning resources. Just remember to consider the effects of taxes and inflation on all your investment returns.

Action Points

  Evaluate and understand the ROI you can realistically expect from every investment opportunity.

  Include the risk of loss in your evaluation of ROI, and compare apples to apples based on expected return.

  Avoid risking more than you can afford to lose on a single investment.

  Sort and prioritize your investment opportunities with the highest expected returns at the top of the list.

  See all your resources as part of one large pool, and make one large list of opportunities so you can allocate resources across and between areas of your life and/or work.

  As much as is practical, allocate your resources to the highest-ROI investments at the top of the list, and say no to all other opportunities.

  Include the effects of taxes and inflation in your evaluation of ROI.

Engage Online

Find links for further study on analyzing ROI at www.aardsma.com/investingbook.