Joseph Wang Financial - Comparison Of Returns Of Equities And Fixed Income Long-term

It is very important to correctly compare the returns of equities and fixed income long-term knowingly choose between them

. People see that given a fixed 5% interest and shares of Company X has a dividend yield of 3% and think, what's the trading market for a lower return run a higher risk? . To answer this question one must study the behavior of both long-term options, taking into account:

1) The evolution of capital over the years

2) The evolution of the interest / dividends over the years

3) The influence of inflation on both the capital and in the interests

The share value is compared with the capital invested in fixed income and dividend charged with the interests that are derived from bonds.

First study the evolution of capital and interest / dividend assuming that the earnings per share ( EPS ) and dividend per share of the company grow at a rate of 10%. The share price in the long run follows the path that marks the BPA so consider that also rises by 10% per year, although in practice the price volatility exceeds the volatility of BPA and the dividend and the rise will not occur in a linear and uniform. In this example the fixed income gives a 5% interest, while the dividend yield of the shares at the time of purchase is 3%.

Neither the capital nor the interest on the debt grows, always remain "frozen". The value of the shares and dividends, but growing in geometric progression. The first year is not much difference between the two options (although equity has a higher total return from the beginning) but as time passes, the differences are dramatic.

In the above table we have assumed that are not reinvested or interest of the bonds or dividends on the shares. In case of reinvested both the difference in favor of equities would grow strongly for the interests of fixed income reinvested at a lower rate (5%) than equities (10%). For example, at 50 years in fixed income would accumulate a total (capital + interest) of EUR 1092.13, as shares have a value of EUR 39,888.13 and pay a dividend in that year of EUR 1.196.64.

But in any investment must take account of inflation . We will see the same example assuming an average inflation rate of 4% per year over those 50 years. The following table shows the same values as in the above table but deflated, ie shows the equivalent in today's money. For example, if today with $ 100 can buy food for 10 days in X years with only $ 100 can buy the same food for 2 days. Put another way we can say that 100 euros the year amount to EUR 20 X today because with 100 euros in X we can buy the same with 20 euros today, food for 2 days.

In this table have not been reinvested the interest of the bonds or dividends on the shares. If not, as in the previous case, the difference in favor of equities greatly enhanced.

This second table shows the actual situation and how it can be a young person can not live off the income from the bond lifetime (assuming it meets the average life expectancy) or even "eating" the capital. It is very common to hear friends and relatives that if they won the lottery I'd put all the money in fixed income and live of the interest because "they want to risk". As seen in this last table that option, so sure in appearance, is not only risky but is completely unworkable in the long run. At age 20, for example, your estate would have been reduced to less than half and would have to spend less than half what they spent the first year not to consume any principal. At the moment you have to start spending part of the accumulated capital the road to ruin would be accelerated significantly.

Could be other simulations with different values for the revaluation of BPA and the dividend, average inflation and return on fixed income. The values change but the conclusions would be the same.

by: Joseph Wang

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