The Trap With ROI
You’ve done it! In the last 15 hours, you hustled like crazy, marketed your product, restocked inventory, sold to customers, and netted a 50% ROI! You’ve finally found a business model that can propel your financial position to the stratosphere, and give you the dream life you’ve always wanted! After all, a 50% ROI is unbelievable, and you should be proud… right?
It depends.
If you just spent 15 hours purchasing ingredients, baking 200 chocolate chip cookies, and selling them at the local farmer’s market for $1.50 per cookie, then a 50% ROI doesn’t sound too appealing. Why? Assuming that a cookie costs $1 to make, and earns $0.50 per sale, then you’ve only made $100 in net profit. That works out to be $7 an hour.
Don’t get me wrong, 50% is a great ROI. But context matters and $100 for 15 hours of work is considered an insignificant gain, well below minimum wage.
Now selling cookies is a silly illustration of high effort low reward. But it’s surprising that many investors make this exact mistake in their journey towards financial independence. They often chase “nonmaterial gain”, meaning the monetary reward is insignificant relative to the amount of effort required.
Take Sarah for example. Sarah is a school teacher making $60,000 a year. She doesn’t want her hard earned money wasting away in a savings account at 0.5% interest rate. So Sarah turns to an extremely popular and low barrier option, called the stock market. She decides that in order to maximize returns, she avoids investing in a mutual fund or index fund that averages only 10% a year. Sarah instead tries to pick individual high growth stocks that have the potential to outperform the market. This is often called “Alpha” investing.
Of course the probability of an average investor consistently picking stocks that can outperform the market is extremely low. Even institutional traders, who are smarter than you, have more money than you, and work 80+ hours a week with tools that you don’t have access to, barely beat the market.
But Sarah is persistent and decides to pick stocks anyway. She saves $15,000 to invest. To succeed, Sarah must work extremely hard to determine which stocks to buy or sell. After spending countless hours looking at stock market trends, researching companies, analyzing quarterly earnings reports, watching investment YouTube channels, and reading piles of investment books, Sarah is able to pick stocks that produce a whopping 20% return! This results in a $3000 profit based on her $15,000 initial investment. That is amazing!
Except…
Sarah spent at least 2 to 3 hours a night doing technical analysis to build the right portfolio. If that’s too much time for the average investor, then let’s conservatively imagine that Sarah only spent 7 hours a week trading. That boils down to 28 hours a month, or 336 hours a year. More importantly, with ALL that effort, Sarah only managed to make $8.93 an hour ($3000 / 336 hours). I’m not sure about you, but there are much better ways to earn more than minimum wage.
Now keep in mind that if Sarah had $100,000 to invest, then a 20% return is significant. If she had $1 million, then a 20% return is visibility life changing, especially when compared to a modest 10% return. But the reality is that for most households, a $100,000 investment is completely out of reach. Realistically, the average family only has about $200 to $500 to invest each month, after mortgages and bills are paid.
So what can you do?
For starters, invest in a low cost index fund. It’s very little upfront work, and setting up an account on sites like Vanguard, or Fidelity is a breeze. Had Sarah invested her $15,000 in the Vanguard Total Stock Market index fund (VTSMX), she will earn on average a 10% return, or roughly $1500. She will only spend about 10 minutes a month checking on her account. Based on these metrics, Sarah will actually earn $750 an hour! That’s a bit better than minimum wage right?
Sarah can then use the 300+ hours (time she would have used picking stocks) to advance her career, build a profitable side business, or acquire new skills that can help her achieve greater wealth potential.
In summary
The allure of higher ROIs is often a trap for many individuals on the path to financial freedom. Before taking the leap into your next investment commitment, really take the time to determine both the gain and level of effort required. If the gain is nonmaterial, then it may be better to move to a different strategy, or consider something else entirely.
