Relationship Between Returns On Asset Classes

Question 1

Required return

Answer 1

Required risk-free real rate of return + expected inflation + risk premium

Question 2

Expected return

Answer 2

Initial income yield + expected capital growth
OR
Initial income yield + income growth + impact of change in yield

=> income growth + impact of change in yield = expected capital growth
(Consider equity that pays to perpetuity)

Question 3

When does required and expected returns equal?
When does the investment seem to be cheap?

Answer 3

When assets are fairly priced

When expected return is higher than required return

Question 4

Equity

Answer 4

Over the long term, equity dividend growth might be expected to be close to the growth in GDP, assuming that the share of GDP taken by ‘capital’ remains constant (made up of land, capital and labor)

Question 5

Bonds

Answer 5

For fixed-interest stocks there is no income growth. The initial yield and the capital value change for a bond held to redemption combine to give a fixed nominal total return, called gross redemption yield

The real return on index-linked bonds is known at outset, if they are held to redemption. This real yield is often taken as the benchmark required real yield for the analysis of expected returns on equities

Question 6

Cash

Answer 6

Returns on cash might be expected to exceed inflation expect in periods where inflation is rising rapidly and is under-estimated by investors