Saturday, November 26, 2011

ROI and COI

Please, note the posting order of the ROI and COI series has been changed.

If there is one thing that I have learned over the past 5 years then it is about the relation between ROI and cousin COI. COI is not well known because when dealing with COI we think usually in terms of cash flow, dividend, interest and net operating income. When fractionated, we’re talking about the cash (earned) on cash (invested) ratio or the dividend yield, or the interest rate . COI stands for Cash-On-Investment and ROI most of us know already: Return-on-Investment.

ROI measures how fast our investment portfolio, our net worth increases. When working with compound investments we say that at a ROI of 10% and a 41 year investment time horizon, a one dollar investment growths in value to $64. Wow! But in what form comes that investment return? Is it appreciation; is it income or a combination of both? You may consider someone rich when such a person has a $1million dollar net worth. However, what you should really consider is whether that net worth is tied up in a single home and the fact that it never threw of a single penny of cash. So how would that person live off such a home? In fact, the home still requires cash every year and not just for property taxes. If you own shares in RIM and bought 10 years ago at $1 dollar per share, yes even after its recent decline it may still be worth 18 dollars but how much cash did it provide you to live off or to invest in other opportunities? Not a penny in dividends - cash flow from this investment (COI) was nada, zip, nothing unless you sold the shares.

COI is the cash an investment generates – Cash-on-Investment. It will pay the mortgage, it will pay for your groceries and it is much more dependable than cousin ROI. ROI is market valuation; COI is money in your hand.

In fact, if COI and ROI were really cousins, then for the remainder of this posting we have to get transcendental. Not that a successful investor has to be good at yoga, but COI is an intricate part of ROI. They are two yet they are one :). Cash on investment is a component of your overall return on investment; the other part is the aforementioned appreciation. Whether you invest in stocks or in real estate, appreciation or value increase has not been exactly inspiring over the last five years. Yep, if you invested in gold, appreciation would have been tremendous, but then COI would have been absent (until you sell).

The absence of COI is the reason many investors don’t like gold and they consider it speculative. This is true for most investments; appreciation is unpredictable – it may happen today, next week or five years from now. Nobody knows when a stock will go up in value. However, we all know they typically do. There are long term statistics that show that stock markets appreciate ON AVERAGE around 6 – 8% per year. But, as we lately have experienced, there may be years of depreciation or no appreciation. We don’t know when the goose will lay the golden egg. In the meantime, we have to live of some income. When we neglect COI then usually at the worst possible moment, we may be forced to sell the goose against our will and at a loss.

In real estate, net operating Income pays for financing the debt, for paying down debt and the remainder (usually just a bit) ends up in the investor’s pocket. The less financing (leverage) the more ends up in your pocket. However, higher cash-on-cash also often results in a lower ROI. The stock market phrase for dividend paying stocks is ‘getting paid while you wait’. This is incorrect! What are you waiting for? Appreciation or are you waiting for a high ROI? I would suggest that you invest for ROI of which your cash-on-investment is part. Often COI is the very reliable part of your return that is paid to you typically monthly or quarterly.

Since we’re using expressions, what about: “Better a bird in the hand than ten in the air”? Hmmm! The last five or so years have shown us how important COI (the one bird in the hand) is as part of investment return since appreciation has been all but absent. Cash flow from investment allows us to live; to buy other investments and it helps us to better hold onto our investments during tough times.

So let’s look at diversification in terms of sources of cash flow or COI rather than in terms of asset allocation. How much cash income do you want or do you need? That should be your first portfolio design question. What is the dividend yield on my portfolio? How much interest and how much rental income do I get? Multiple income streams that pay your cost of living and provide cash for reinvestment will protect your portfolio from losing purchasing power (inflation) and possibly helps it to grow into somewhat more. Time for a spreadsheet! Let’s do that in one of the next posts. In the meantime, why not evaluate your own investment portfolio in terms of COI and ROI?

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