Return on an investment tells us as to how well the investment has performed over a period of time. Every investor would want that his money should grow and this depends on the rate of return on the investment where the investor has invested his money in. Therefore returns are the gains or losses from a security in a particular period and are usually quoted as a percentage. The rate of return depends on several factors, such as the macroeconomic conditions, political instability etc. and determine the extent to which investors can meet their financial objectives. A number of outside influences can alter the returns on stocks and bonds and even on fixed income investments like CDs and savings accounts. So here is a detailed explanation of various factors that can influence the return on investments:
In the context of investment, risk refers not only to the chance that a person may lose his capital but more importantly to the chance that the investors may not get the desired return on an investment vehicle. As we all know that risk and return go hand in hand, this means that without risk there is no or minimal return. Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. Investment risks can be divided into two categories: systematic and unsystematic.
- Systematic (market) risk is the uncertainty in a security’s total returns that are directly associated with over-all movements in the general market or economy. Interest rates, recession, and wars all are the sources of systematic risk because they affect the entire market and cannot be avoided through diversification. Systematic risk can be avoided only by hedging.
- Unsystematic risk is the uncertainty in the variability in security’s total returns not related to the overall market variability. This risk is unique to a particular security. It can be reduced through diversification. For example, news that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares in, is considered to be an unsystematic risk.
- Monetary policy
The central bank of a country controls the money supply in the economy through its monetary policy. The monetary policy primarily aims at price stability and economic growth. If the RBI loosens the monetary policy (i.e., expands money supply or liquidity in the economy), interest rates tend to get reduced and economic growth gets spurred; at the same time, it leads to higher inflation. During this period investors expect a higher return on their investments.
On the other hand, if the RBI tightens the monetary policy, interest rates rise leading to lower economic growth; but at the same time, inflation gets curbed. Lower economic growth leads to a reduction in the returns of investments made by the investors. So, the RBI often has to do a balancing act. The key policy rate the RBI uses to inject/remove liquidity from the monetary system is the repo rates. Changes in repo rates influence other interest rates too.
- Political Instability
Political instability either in your home country or abroad can have a major impact on your earnings. It can lead to a reduction in the rates of returns on investments. For example toppling of a democratically elected government can lead to a crash in the prices of stocks. This tends to affect it for a reasonable period of time depending on the severity of the situation.
If there is political stability then it creates investor and business confidence because there is more visibility into possible investment returns. Investors tend to avoid countries that change governments frequently or have civil strife.
- Business cycles
The return on investment can also get affected by external factors, which are beyond the control of a company involved. One such external factor is the business cycle. The business cycle is the fluctuation in economic activity that an economy experiences over a period of time. When the economy is in the phase of expansion the earnings of the companies increase and also does the return on investments. This phase is evidenced by an increase in indicators like employment, industrial production, sales and personal incomes. People start feeling great about the economy, investors often bid up stocks past their fair value, resulting in higher returns and happier shareholders.
But when the economy enters a recession, the earnings of most companies decline. This phase is evidenced by a decrease in indicators like employment, industrial production, sales and personal incomes. When those earnings fall, the stock price often follows and it falls. Fears of a recession, or simple uncertainty about the future direction of the economy, can also affect the return on your investment.
- Company growth rates
The rate of growth in a company’s revenue and earnings can have a strong impact on its stock price and the return you get from it. Investors tend to place a higher price/earnings multiple on companies in their rapid growth phase when earnings can grow 20 percent or more year over year. As the growth in earnings and revenue slows, the value investors place on the company can decline as well. Investors often refer to the price/earnings (P/E) ratio when valuing stocks — the P/E ratio is simply the relationship between the earnings per share and the price of the stock. It is easy to calculate P/E by dividing the current price of the stock by its annual earnings.
Taxes can influence the investment returns. Different types of investments are taxed differently. For example profits on stocks that are held for more than a year are known as long-term capital gains, and they are taxed at a rate other than what is taxed on ordinary income. The current long-term capital gains tax rate is 20 percent for individuals.
Short-term capital gains are the profit on investments held for a year or less. The current short-term capital gains tax rate for some securities covered under section 111A is 15 percent for individuals. And for all other securities, the gain will be included in the taxable income and would be taxed accordingly.
Investors have to pay brokerage fees to buy and sell certain investments. They also pay management fees. These fees diminish investment returns.
The frequency with which the investment returns are reinvested and are able to earn additional returns can significantly impact the total returns. The reinvestment of investment returns is known as compounding. The more frequently earnings are compounded, the better. Daily compounding is better than annual compounding.