Corporate finance talks about it; investors and speculators talk about it.
When we invest our money, there is a natural expectation that we earn a fair rate of return on it. It is true whether we buy bonds or stocks.
Since debt has a fixed coupon on it, there is no confusion regarding expected return. A 10% bond due whenever, has expected return of 10%, not more not less, unless of course we are keen on investment at discounted prices.
It gets a bit complicated when it comes to equity investment. The world is just confused about what to expect from it. There is consensus that returns from equity investments require extra profits when compared to any other investments. That ends here however. How much extra returns, it's a hot debate out there.
Equity investment expects returns higher than that of cash, money market, government bond or corporate bond; while this expectation is given, there is no guarantee that it will actually provide that. Lop-sided equity investment can yield far lower return compared to the other so-called low-return investments.
Assuming investments are made in a more sensible manner, it will be interesting to analyze how we should expect returns.
We have some alternatives after we ignore the famous risk-return models of corporate finance.
We could find out historical equity returns over a fairly long period of time and expect that rate to prevail in future as well. This is a reasonable assumption even when one can argue that, times have changed. We can consider 10-15% annual compounded rate as a reasonable rate to expect from equity markets.
We could take long-term government bond rate, add a few points to it and consider that as expected rate for equity investment. Corporate bonds are not considered here as they have much higher default risk.
We could estimate long-term inflation rate, add a few points to it and consider that as expected rate for equity investment.
It is important to note certain fundamental and implied assumptions in every equity investment: compensation for postponing present consumption and uncertainty associated with long time period, and expectation to at least (perhaps more) maintain current purchasing power.
If these arguments are accepted, we come to a logical conclusion that equity investors need to be rewarded with a rate that is not less than inflation rate to start with. Once this expectation is met, there should be some additional points for forgoing present consumption and for assuming some uncertainty. Now, there is no exact science to compute these additional points to precision (if there is one, you go for it). Why not add as you deem fit albeit within reasonable boundaries? It does not bother us if investors add 5 to 10 points above inflation rate.
Equity investment fails to be an investment if it does not guarantee a rate at least equal to the inflation rate.
Consider this:
1) Expect market rate of return (hopefully this exceeds inflation rate; we have no particular reason to reject this), if you do not want to work hard either because you have no time or do not enjoy the process or because you think there are better things in life than spending time on equity analysis. Here your best bet is investment in the equity index itself. One thing is guaranteed: no one will question your judgment or rate of return achieved in the long run. For, many so-called sophisticated and well-equipped investors and investment-managers know how difficult it is to beat the market.
2) Expect inflation-plus-some-points depending on whether and how much efforts you are willing to put in. If you are not to be bothered, you need to join those passive investors and expect market rates. If you are more willing to put in time and enjoy the process, you should expect some higher points for your efforts. How much higher is directly proportional to how much time you have spent on analyzing the business and gap between its value and price. However remember this: on a long-term basis, it is not possible to exceed the inflation rate or market return by say, 5-10 points. For an ordinary investor, an additional 5% will have made more than adequate return compounded in the long run. Pick a rate and try its power of compounding over say, 20-30 years, and you will know why.
Now, it amazes me as to why one should think too much about return expectations. As someone once said, it is better to be roughly right than be precisely wrong. So add those points and move on.
When we invest our money, there is a natural expectation that we earn a fair rate of return on it. It is true whether we buy bonds or stocks.
Since debt has a fixed coupon on it, there is no confusion regarding expected return. A 10% bond due whenever, has expected return of 10%, not more not less, unless of course we are keen on investment at discounted prices.
It gets a bit complicated when it comes to equity investment. The world is just confused about what to expect from it. There is consensus that returns from equity investments require extra profits when compared to any other investments. That ends here however. How much extra returns, it's a hot debate out there.
Equity investment expects returns higher than that of cash, money market, government bond or corporate bond; while this expectation is given, there is no guarantee that it will actually provide that. Lop-sided equity investment can yield far lower return compared to the other so-called low-return investments.
Assuming investments are made in a more sensible manner, it will be interesting to analyze how we should expect returns.
We have some alternatives after we ignore the famous risk-return models of corporate finance.
We could find out historical equity returns over a fairly long period of time and expect that rate to prevail in future as well. This is a reasonable assumption even when one can argue that, times have changed. We can consider 10-15% annual compounded rate as a reasonable rate to expect from equity markets.
We could take long-term government bond rate, add a few points to it and consider that as expected rate for equity investment. Corporate bonds are not considered here as they have much higher default risk.
We could estimate long-term inflation rate, add a few points to it and consider that as expected rate for equity investment.
It is important to note certain fundamental and implied assumptions in every equity investment: compensation for postponing present consumption and uncertainty associated with long time period, and expectation to at least (perhaps more) maintain current purchasing power.
If these arguments are accepted, we come to a logical conclusion that equity investors need to be rewarded with a rate that is not less than inflation rate to start with. Once this expectation is met, there should be some additional points for forgoing present consumption and for assuming some uncertainty. Now, there is no exact science to compute these additional points to precision (if there is one, you go for it). Why not add as you deem fit albeit within reasonable boundaries? It does not bother us if investors add 5 to 10 points above inflation rate.
Equity investment fails to be an investment if it does not guarantee a rate at least equal to the inflation rate.
Consider this:
1) Expect market rate of return (hopefully this exceeds inflation rate; we have no particular reason to reject this), if you do not want to work hard either because you have no time or do not enjoy the process or because you think there are better things in life than spending time on equity analysis. Here your best bet is investment in the equity index itself. One thing is guaranteed: no one will question your judgment or rate of return achieved in the long run. For, many so-called sophisticated and well-equipped investors and investment-managers know how difficult it is to beat the market.
2) Expect inflation-plus-some-points depending on whether and how much efforts you are willing to put in. If you are not to be bothered, you need to join those passive investors and expect market rates. If you are more willing to put in time and enjoy the process, you should expect some higher points for your efforts. How much higher is directly proportional to how much time you have spent on analyzing the business and gap between its value and price. However remember this: on a long-term basis, it is not possible to exceed the inflation rate or market return by say, 5-10 points. For an ordinary investor, an additional 5% will have made more than adequate return compounded in the long run. Pick a rate and try its power of compounding over say, 20-30 years, and you will know why.
Now, it amazes me as to why one should think too much about return expectations. As someone once said, it is better to be roughly right than be precisely wrong. So add those points and move on.
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