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3 main factors may cause ROI to fluctuate and what you can do to stabilise it

When you thought of investing your money, the expected return on the investment probably impacted your decision. The rate of return on investment (ROI) is the ratio between investment and net income. ROIs are influenced by a variety of factors, such as portfolio, market, and economic conditions.

Here we look at some of the causes why your ROI may fluctuate and what can be done to minimise it:

1. Understanding ROI fluctuation

The ROI is used to calculate the rates of return on money invested to determine whether or not to invest. It is also used to assess the performance of different assets in an investment portfolio. Most investors will be looking for investments with the highest ROI, even though they should consider other factors, like dispersion of ROI and adjusting it with time. 

While ROI calculations are useful to read the profitability of investments, they are also quite limited in usage. One limitation of ROI is that it does not account for the long-term or short-term period in its calculation, nor does it account for the social, environmental, and governance in its measurement. Without these factors, decision-makers are essentially planning a future blindly where these factors can impact the ROI.

Another limitation of ROI measurements is that the calculation is too simple and allows investors to choose any variable they want (such as periods or costs) as long as they get the answer they want, even if it is misleading. For example, ROI in long-term investments cannot be correct without the Net Present Value.

2. What causes ROI to fluctuate?

Now comes the main question - what causes your ROI to fluctuate? Well, a number of things, like economic factors, costs associated with your investment, and your own behaviour, may impact your ROI. If you are a new investor, it could be especially difficult to pinpoint what exactly is causing your returns to fluctuate. As a result, it would also become difficult to do something about it. Fortunately, vast sources are out there to explain the common causes of ROI fluctuations. This article is one of them.

We will analyse and evaluate all the possible circumstances in the following:

  • Economic factors
  • Investment costs
  • Investor behaviour

Economic factors

Economic factors consist of many complex conditions that affect your ROI. As Economic success is tied to equities and debt instruments, and other forms of investments, any change in the economic condition will likely impact those investments too. A successful economy means growing businesses, which would mean paying their equity and debt holders handsomely. Likewise, the opposite happens when the economy slows down - businesses suffer, and so do equity and bondholders' ROIs. A growing economy also means that more people are employed, and they have the means to buy the products/services of the companies that issue the equities and debt instruments. Additionally, a growing economy means higher ROI, which sounds good at first, but it makes credit more expensive affecting consumer spending and investments in the long run.

Economic situations also include political and regulatory factors that cause the ROI to fluctuate. State budget cuts can cause higher borrowing costs for businesses, ultimately impacting their issues and interest rates. Legal bureaucracy can limit business investments in sectors which could also limit potential ROI growth for investors. Political instability will cause investors to lose confidence in both businesses and the government, negatively impacting their ROI on their issued instruments.

Investment costs

Investment costs consist of fees and taxes, both of which we will explore. Investment fees are the primary cause of decreased ROI due to its consistency and its ability to compound over portfolio growth. Even though they appear small in percentages, they eventually increase and cause drag on ROI. Studies have shown that fees can reduce ROI by an average of 29%. Fortunately, many investors advocate for low-cost investing and recommend measuring the expense ratio to determine whether the fees are justified. The recommended rate for expense ratio is between 0.5% to 0.7% for active funds and 0.2% or less for passive funds.

Understanding how your investments are taxed is critical to ROI fluctuations. The government taxes all incomes, and investment income is no exception. Of course, pensions are one investment exception unless you take it out before the retirement period. Then there is capital gains tax, which you have to pay if you sell your investments for profit. Taxes also depend on the country you live in since both income tax and capital gains tax may be lower in those countries, and in some countries, there may be no capital gains taxes at all. Some countries will give tax breaks on investments to boost your portfolio. Once you know the real rate of taxes and any tax benefits, you can decide where to allocate your investments more to maximise your ROIs.

Investor behaviour

Investment behaviour is a major contributor to ROI fluctuation, and many financial incidents and countless studies have proven that. For example, investors panicked and sold everything with the S&P500 index fell by 14% in 2018 without looking at the bigger picture. The investors missed out on the bounceback by 11% in 2019. As such, we look at some of the most common investor behaviour that causes the ROI to fluctuate in the following:

  • Poor asset allocation: Poor asset allocation has a lot to do with poor diversification. Where diversification aims to minimise risk, poor asset allocation distributes your investment without considering the risk exposure of each asset. In fact, studies have found a diversification bias, where investors would choose more options, hoping it would maximise their profits. However, such a notion is false. This behaviour leads to a significant positive correlation between the assets where, if one asset suffers losses, the other one would too. Investors need to adjust risk exposure by allocating assets with volatility that can be counterbalanced
  • Overreaction to media hype: People are known to overreact to bad news, and investment is no different. Due to fear of loss and greed, investors often lose sight of the bigger picture and end up causing financial harm to themselves. Panic selling and buying high are very common. In such cases, investors need to understand the nature of their investment to determine whether to sell or hold onto it for a larger ROI in the future 
  • Time mismanagement: Time mismanagement has two forms - one is not starting early with investments, and the second is thinking short-term profits only. On both bases, long-term investment is key to ROI growth because of the power of compounding and bounceback of fallen investments. It is common for investments to lose value over the short term. However, investors panic because they were subconsciously aiming for short-term growth. An example of this is the history of Black Monday, where the DOW went down by 22% in 1987. The investors panicked and jumped ship only to miss out on the bounceback profit when it went up by 31.7% in 1989. Had those investors thought of the long-term, they would have benefitted from such growth 

ROI fluctuations are nothing to fear because they are preventable. Investors need to dive deep into their portfolios and take all the measures necessary to hedge against volatile fluctuations. Although, we should admit that not all factors can be prevented, like regulatory and political factors, and in those times, investors should do what is best for their circumstances. Otherwise, you can very much manage other conditions, especially investor behaviour. 

Last update: 10/08/2021

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Disclaimer: Some text on this website is purely for marketing communication. Nothing published by Quanloop constitutes an investment recommendation, nor should any data or content published by Quanloop be relied upon for any investment activities. Quanloop strongly recommends that you perform your own independent research and/or speak with a qualified investment professional before making any financial decision.