Choosing Between Assets

Question 1

What environment makes the decision to invest in stocks easy?

Answer 1

When interest rates are low.

Question 2

Why are bonds an easy choice in a high interest rate environment?

Answer 2

You can get a high return with the much lower risk of bonds compared to equities.

Question 3

What spread helps us value stocks versus bonds?

Answer 3

The spread between the earnings yield on the S&P 500 and the 10 year bond

Question 4

Can the dividend be used against the bond yield to compare assets?

Answer 4

Yes on its own, or added to the Earnings Yield to compare against bonds.

Question 5

Can any other type of bond yield be used in this equation?

Answer 5

We could use the corporate bond yield instead of the long Treasury Bond?

Question 6

Why are costs important in asset comparison?

Answer 6

As an eg Real Estate has management fees, maintenance costs, insurance, mortgages versus stocks just pay the commission going in and out.

Question 7

Why should I consider reinvestment risk when comparing assets?

Answer 7

Some assets throw off cash which I then have to work out how to reinvest. Alternatively, stocks of good growing comparing can reinvest my earn earnings for me and throw off an increases stream of income.

Question 8

What protections do Equities have against rising bond yields?

Answer 8

Earnings growth or a high enough level of dividend yields.

Question 9

Which type of assets add the best diversification benefits?

Answer 9

non correlated assets. Means thans that one asset zigs while the other zags. Relationship not constant over time but more of a generalization.

Question 10

What are 4 attractive attributes of diversification?

Answer 10

1) Reduces risk/volatility
2) Improves risk adjusted returns
3) Reduces max drawdown
4) reduces time in drawdown mode

Question 11

Give an example of max draw down on a 6040 PF versus stocks using data back to 1950?

Answer 11

A notional 6040 PF going back to 1950 had a max draw down of only 29% versus 52% for stocks.

Question 12

Does diversification work all the time?

Answer 12

No, often in a crisis all assets literally go to 1 and move together.

Question 13

The case against investing in one single asset class and for diversifying.

Answer 13

Asset class returns can be extreme. 
Whether US equities late '20s, German in '40s, Japan 1990-2015, max drawdown can be so large that recover might take investors entire life.

Question 14

What do studies say about where return variability comes from?

Answer 14

Studies show that 70% of return variability is derived from asset allocation, 20% from sub-asset allocation (country, size, style) and 10% from security selection.

Question 15

When we think about the risk of one asset versus another, we have to consider the risk/volatility of different assets. What is beta?

Answer 15

beta - an assets sensitivity compared to a broad market. A beta of 1.2 is 20% more sensitive than the broad market

Question 16

Another measure of volatility is called standard deviation. What is it?

Answer 16

measures the inherent volatility of the asset itself. Here we are looking at an assets volatility compared to its own performance over a period of time.
Govt bonds have a SD of 10, Large stocks 20, small stocks 30, Corp Bonds 9.5, Intermediate bonds 6.8

Question 17

What important risk is not captured by either beta or standard deviation?

Answer 17

That the return will be bad.

Question 18

Two other ways to think about risk?

Answer 18

Cumulative draw down over say a 2-3 year period or

Time to recovery of capital value.

Question 19

Describe 3 different ways to think about equity or market risk premium?

Answer 19

They are the either

1) the historical market risk premium based on returns that have already occurred - typically equities v bonds. This can be seen to represent an excess return.
2) The more subjective expected market risk premium based on return projections
3) the premium required by investors to allocate capital to equities over bonds. Equities are inherently more risk than bonds which pay steady interest and return a known principal value.

Question 20

What are 5 types of models used to estimate the ERP?

Answer 20

1) predictors that use historical mean returns only, 2) dividend-discount models, 3) cross-sectional regressions, 4) time-series regressions and 5) surveys.

Question 21

What are long run estimates of the ERP level?

Answer 21

According to some sources, the equity risk premium ranges between 4% and 7% over the long term

Using a database of 21 countries going back to 1900 the realised equity risk premium over government bonds has been 3.4% annually (robecco)

Question 22

What was the ERP estimated to be during the GFC? What was the reason for this?

Answer 22

10.5%.

Reason: global CB intervention and artifically low interest rates.

Question 23

What about the ERP after the GFC?

Answer 23

According to the Federal Reserve Bank of New York, the equity risk premium reached abnormally high levels in 2012 and 2013 of about 12%, due to extremely low bond yields.

Question 24

What other reasons have led to significant change in the ERP?

Answer 24

But the equity risk premium has experienced other periods of material shifts, with one early notable period being the post-World War era where the risk premium rose thanks to greater confidence and appetite for risk.
A more recent period of note was the higher-than-usual equity risk premium experienced after the tech bubble of the late 1990s.

Question 25

How is the ERP calculated?

Answer 25

The equity risk premium is calculated as the difference between the estimated real return on stocks and the estimated real return on safe bonds – that is, by subtracting the risk-free return from the expected asset return (the model makes a key assumption that current valuation multiples are roughly correct).

Question 26

Why is the ERP important to investment decisions?

Answer 26

It is used to calculate the cost of capital for companies.
The equity risk premium is the main input in both the capital asset pricing model, and in asset allocation decisions between stocks and bonds. If investors have a more objective idea of the relative returns to stocks, bonds and cash, they can make better decisions about how to invest their money into these three asset classes.

Anyone who has money in a retirement plan must decide how to allocate their money between stocks, bonds and cash. The equity risk premium indicates how much more an investor may earn by investing their money in the stock market rather than in government bonds. If the equity premium is high, people should allocate more of their portfolio to stocks, if it is low, then more to bonds.

Question 27

Why is it suggested that the ERP has declined over time?

Answer 27

Increases in market liquidity along with improvements in trading technology and record keeping.
Innovations in capital market regulation and oversight to protect investors including the establishment of the Securities Exchange Commission.
Advances in economic theory and policy leading to increased stabilization of the economy.
Advances in asset pricing and portfolio theory leading to improved risk measurement and investment management.
The expansion of stock market participation via the invention of mutual funds and the creation of the modern retirement savings system.

Question 28

Does the ERP have value over the shorter term or longer term basis?

Answer 28

One a 1 year basis there is almost no correlation between the ERP and the performance of equities.
However this improves on a 3-5 yr view.

Question 29

When was the ERP particularly low?

Answer 29

It was particularly low during the 1930s depression and the oil price shocks of the 1970s, when the US experienced low growth and high inflation. That resulted in exceptionally high short-term Treasury rates – the US Federal Reserve raised the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981 – and low equity returns.

Question 30

Why have historical ERP values been suggested to show high variability?

Answer 30

attributed to shifts in non-diversifiable macroeconomic risks and others to behavourial biases such as overconfidence and “irrational exuberance”.

Question 31

Relate valuation to the statement that the price you pay influences your rate of return….

Answer 31

If you pay a below average price (PE/CAPE) then you can expect above average rate of return.

Vice versa.

Question 32

What is the full sample LT cape of the US market? versus what is the low inflationary period average CAPE?

Answer 32

16.5x since 1900, versus 21x for the low inflationary periods.

Question 33

Outline return expectations based on different levels of CAPE?

Answer 33

When the CAPE is <10x, the forward expected return is ~12%, 10-15x ~8%, 15-20% ~5%, 20-25x ~3%, >30x it is negative.

Question 34

What has been a great place to invest when Equities are very overvalued (CAPE > 30x)?

Answer 34

10 yr bonds

Question 35

In a broad sense what is the Bogel formula?

Answer 35

Bogel formula helps to forecast what stocks (equities) will do in next 10 yrs

Question 36

What are the three main components of the Bogel Formula?

Answer 36

Starting div yield, future div gth and change in valuation

Question 37

How does the formula get us to a nominal 10% return on equities?

Answer 37

the 10% nominal historically comes from an average starting div yield of 4.8%, div gth of 4.9% and a slight bump of stocks getting more expensive - 0.3%.

Question 38

So using the todays data what would the Bogel formula say just using Div yield + growth of dividends?

Answer 38

DIv Yield is 1.9% and add to that 5% for Div Growth

Question 39

Show off the Bogel valuation change calcs for the current environment assuming both LT average CAPE and low inflationary CAPE.

Answer 39

28x - 21x (low inflation) = 25% fall or -2.5% pa over 10 yrs

28x to 17x (full sample) = 40% fall or -4% pa over 10 yrs

Question 40

Based on all available data, show off current Bogel return expectation calcs for a low inflation and full sample of historic data?

Answer 40

1. 9% div yield + 5% div growth -2.5% (low inflation) = 4.4%

1. 9% div yield + 5% div growth -4% (full sample) = 2.9%

Question 41

Comparing stocks and bonds, bonds are financial instruments with static coupons while stocks have XXXXXX coupons?

Answer 41

ascending