Relationship between returns on asset classes (Expected return on…
Relationship between returns on asset classes
Formulae for required and expected return
Risk-free real return + expected inflation + risk premium
initial income yield + expected capital growth
Comparing the required and expected returns
If equal the assets are fairly priced
If expected > required the asset appears cheap for that investor
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
Might be expected to be 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. The dilution effect 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
In periods when inflation turns out to be higher than had been expected, real returns from fixed-interest stocks are lower than expected and are poor compared with equities
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 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 grow in line with GDP (i.e. economic growth)