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Relationship between returns on asset classes (Situations where the real…
Relationship between returns on asset classes
formulae
required return
Risk- free real return + expected inflation + risk premium
expected return
initial income yield + expected capital growth
equities
dividend yield + expected nominal dividend growth
conventional bonds
GRY (nominal)
index-linked bonds
GRY (real)
property
rental yield + expected nominal rental growth
cash
short-term nominal interest rates
Assumption for equating the required and expected return
assets are fairly priced (i.e. the market is efficient)
other
all investors want a real rate of return
all investors have the same time horizon for investment decisions
tax differences between investors can be ignored
reinvestment can occur at a rate equal to the expected total return on the asset
equity dividend growth assumption
close to economic growth (growth in GDP)
assumes share of GDP represented by capital remains constant over time
dilution effect due to the need for companies to raise new equity capital from time to time if dividend yields are high
also depends on the extent to which economic growth is generated by start-up companies
Situations where the real return on conventional bonds will be poor
If inflation turns out to be higher than expected, real returns from fixed-interest stocks are lower than expected and are poor compared with equities
if bond sold before maturity, the return= (sale price + income received)/ purchase price
in periods when yields are rising, real returns from fixed-interest stocks are poor
expected return on cash
returns on cash might be expected to exceed inflation except in periods where inflation is rising rapidly and is under-estimated by investors
short term real interest rates can also be kept very high or very low by governments for significant periods
expected wages growth
a reasonable assumption over the long term would be that wages would grow in line with GDP