Relationship between returns on asset classes (Expected return on…
Relationship between returns on asset classes
Formulae for required and expected return
Required return= risk-free real return + expected inflation + risk premium
expected return= initial income yield + expected capital growth ≈ initial income yield + income growth + impact of change in yield
Assumptions for equating the required return and expected return
assets fairly priced (i.e. the market is efficient).
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.
Expected return on different asset classes
dividend yield + expected nominal dividend growth
rental yield + expected nominal rental growth
short-term nominal interest rates
Equity dividend growth assumption
Close to economic growth (growth in GDP) but this assumes that the 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
periods when inflation turns out to be higher than had been expected, real returns from fixed interest stocks are lower than expected and poor compared with equities
In periods when yields are rising, real returns from fixed-interest stocks are poor
Note if bonds yields i.e. GRY are rising then bond prices are falling. Hence return falls.
if sold before maturity return = (sale price + income received)/ purchase price
Expected return on cash
may 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
wages grow in line with GDP,