14 - Relationship between returns on asset classes

Question 1

State the formula for the required return on an asset

Answer 1

Required Return = risk free return + expected inflation + risk premium

Question 2

State the formula for the expected return on an asset

Answer 2

Expected return = initial income yield + expected capital growth

Approx = initial income yield + income growth + impact of change in yield

Question 3

What does it mean if the required return equals the expected return?

Answer 3

The assets are ‘fairly priced’

Question 4

What does it mean if the required return for an investor is less than the expected return

Answer 4

The asset appears cheap for that investor

Question 5

Formula for the expected return on equities

Answer 5

Equities = dividend yield + expected nominal dividend growth

Question 6

Formula for the expected return on conventional bonds

Answer 6

Conventional bonds = GRY (nominal)

Question 7

Formula for the expected return on index linked bonds

Answer 7

Index linked bonds = GRY (real)

Question 8

Formula for the expected return on property

Answer 8

Property = rental yield + expected nominal rental growth

Question 9

Formula for the expected return on cash

Answer 9

Cash = short term nominal interest yields

Question 10

Over the long term, what is equity dividend growth expected to be close to?

Answer 10

It might be expected to be close to economic growth (growth in GDP), but this assumes that the share pf GDP represented by capital remains constant over time.

There is, however, a 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.

Question 11

Give two examples of when real returns on conventional bonds will be poor.

Answer 11

1. In periods when inflation turns out to be higher than expected.
2. In periods when yields are rising, real returns from fixed interest stocks are poor.

Question 12

Discuss the factors affecting the expected return on cash

Answer 12

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 interest rates can also be kept very high or very low by governments for significant periods.

Question 13

Over the long term, what are wages expected to grow in line with?

Answer 13

A reasonable assumption will be growth in line with GDP (i.e. economic growth)