What Factors Influence the Rates of Return on an Investment?
When you decide to invest your finances, the chances are good that the estimated return of the investment asset (which could be stocks, bonds, real estate, mutual funds, etc.) has factored significantly into your decision. The rate of return on an investment asset can be defined as the income and capital appreciation over a measurement period divided by the cost of acquisition, expressed as a percentage. Not surprisingly, the rates of return depend on several factors, such as the portfolio composition and macroeconomic conditions, among others. These return rates will largely determine the extent to which you, the investor, can meet your financial objectives.
Factors that influence your rate of return include the mix of assets, the business's strategy and operations, the state of the economy, political stability, fiscal policy and regulations.
The Ideal Asset Mix
The asset mix of an investment portfolio determines its overall return. There is a risk-return tradeoff with every asset – the higher the risk, the higher the volatility and return potential. For example, stocks are generally riskier and more volatile than bonds, but the rates of return on stocks have exceeded those of bonds over the long term.
An investment portfolio fully invested in stocks is likely to suffer in a down economy and during periods of high market volatility. On the other hand, a conservative portfolio invested mainly in high-quality bonds is likely to have lower, although more predictable and stable returns.
Strategic and Operational Fundamentals
The strategic and operational fundamentals of the underlying businesses affect investment returns. Strategy involves positioning a company to take advantage of opportunities and responding effectively to competitive threats. Operational execution involves managing costs, expanding into new markets and continually innovating to stay ahead of the competition.
Companies that consistently meet sales and profit expectations generally see their stock prices outperform market averages. Conversely, companies that lose market share and miss earnings expectations almost always underperform the market.
The General Economy
Macroeconomic conditions affect investment rates of return. A growing economy means that more people have jobs, which means they spend more. For businesses, this leads to increases in sales, profits and investments in new employees and equipment. However, rapid economic growth can lead to higher interest rates. This makes credit more expensive, thus dampening consumer spending and business investments.
Economic slowdowns lead to low employment, which usually means lower profits and stock prices. The resulting weakness in the stock markets could improve bond prices as investors move funds to the relative safety of bonds.
Government and Political Factors
Fiscal policy, regulations and political stability also affect investment rates of return. Large fiscal deficits reduce government flexibility and may result in higher borrowing costs for businesses. An arduous regulatory approval process can hamper business investments in the resource and energy sectors. Political stability 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.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.