Sunday, 14 August 2016

A Random Walk Down Wall Street - Part Four 2: A Practical Guide for RANDOM WALKers and other Investors

Chapter 13. Handicapping the Financial Race: A Primer in Understanding and Projecting Returns form Stocks and Bonds.

1. Very long-run returns from common stocks are driven by two critical factors: the dividend yield at the time of purchase, and the future growth rate of earnings and dividends.

2. The long-run total return for either an individual stock or the market:
Long-run equity return = Initial dividend yield + Growth rate

3. Over shorter periods, say, several years, a third factor is critical in determining returns. It is the change in valuation relationship – specifically, the change in the price-dividend or price-earnings multiple.

4. The multiples vary widely from year to year. They are affected by interest rate and mass psychology among many things.

5. Estimating bond returns becomes murky when bonds are not held until maturity. Bond investors who don’t hold to maturity will have their return increased or decreased depending on what happens to interest rates in the interim.

6. Inflation is the dark horse in any handicapping of financial returns. In principle, common stocks should be an inflation hedge and stocks are not supposed to suffer with an increase in the inflation rate. In theory at least, if the inflation rate rises by 1%, all prices should rise by 1%, including the values of factories, equipment, and inventories. Consequently, the growth rate of earnings and dividends should rise with the rate of inflation, so will the required return on common stocks. However, very high inflation rates are very bad for economy. When price rise by 10%, all prices do not rise by the same amount. Rather, relative prices are far more variable at higher levels of inflation. Furthermore, the higher the rate of inflation, the more variable and unpredictable inflation becomes. Thus, more volatile levels of real output and higher inflation rates, as well as the accompanying greater volatility of interest rates, increased uncertainty throughout the economy.

A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel

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