Investment Notes

Historical Rates of Return

• Investment Scenario (2005):
  • Initial investment: $10,000$ in 2005.
  • Investment options:
    • Australian shares: Top 500 ASX companies (S&P/ASX All Ordinaries Index).
    • Australian bonds: Investment-grade Australian bonds (Treasury, semi-government, corporate).
    • Cash: Short-term money market instruments (overnight cash, 1-3 month bank bills).

Performance of Different Asset Classes (2005-2024)

• Portfolio Values and Returns (as of Dec 31, 2024):
  *Australian Shares:
  * Value: $47,194$
  * Effective Annual Return: $8.1\%$
  *Australian Bonds:
  * Value: $22,858$
  * Effective Annual Return: $4.2\%$
  *Cash:
  * Value: $19,516$
  * Effective Annual Return: $3.4\%$
  *Inflation:
  * Value: $17,104$
  * Effective Annual Return: $2.7\%$

• Questions addressed:

  • Portfolio value as of December 31, 2024.
  • Effective annual return over 20 years (2005-2024).
  • Comparison of returns to inflation.

Risk Considerations

• Negative Returns:

  • Australian Shares: experienced negative returns in 2008 (-40.4%), 2011 (-11.4%), 2018 (-3.5%), and 2022 (-3.0%).
  • Australian Bonds: experienced negative returns in 2021 (-2.9%) and 2022 (-9.7%).
  • Cash: No negative returns over 20 years.

• Standard Deviation:

  • Definition: A measure of risk indicating the tendency of historical returns to deviate from their average.
    • Australian Shares: $16.6\%$
    • Australian Bonds: $5.1\%$
    • Cash: $2.1\%$

Risk-Return Trade-off

• Principle: Investors have historically earned higher returns on riskier investments.
• Risk Aversion: Investors prefer a certain return over an uncertain one.
• Incentive for Risk: Higher expected returns are offered on riskier investments to compensate investors.
• Expected vs. Actual Return: Expected return may not always equal realised return.
  • During the 2008 financial crisis, Australian shares returned -40.4%, while Australian bonds returned 14.9%.

International Asset Classes

• Investment Options:

  • US Shares: Top 500 US companies (S&P 500 Index).
  • International Shares: 1,300 companies across 22 developed markets (excluding Australia).
  • International Bonds: Investment-grade international bonds (excluding Australia).

• Performance Comparison:
  *US Shares:
  * Value: $90,867$
  * Effective Annual Return: $11.7\%$
  * Standard Deviation: $18.0\%$
  *International Shares:
  * Value: $58,941$
  * Effective Annual Return: $9.3\%$
  * Standard Deviation: $16.8\%$
  *Australian Shares:
  * Value: $47,194$
  * Effective Annual Return: $8.1\%$
  * Standard Deviation: $16.6\%$
  *International Bonds:
  * Value: $24,781$
  * Effective Annual Return: $4.6\%$
  * Standard Deviation: $5.3\%$
  *Australian Bonds:
  * Value: $22,858$
  * Effective Annual Return: $4.2\%$
  * Standard Deviation: $5.1\%$
  *Cash:
  * Value: $19,516$
  * Effective Annual Return: $3.4\%$
  * Standard Deviation: $2.1\%$

• Observations:

  • US shares had the highest return but also the highest risk.
  • The risk-return trade-off holds across international asset classes.

Risk-Return Trade-Off Summary

• Investor Behavior: Risk-averse investors require higher expected returns for higher-risk assets.
• Compensation for Risk: Investors must be compensated with a higher expected return to invest in riskier assets.

Risk-Return Trade-Off Examples

• Bonds vs. Ordinary Shares:

  • Bonds: Exchange cash for promised interest and face value; contractual cash flows; paid before shareholders in bankruptcy.
  • Ordinary Shares: Exchange cash for ownership; dividends not guaranteed; residual claim on assets after creditors and bondholders.
  • Conclusion: Expected return on ordinary shares (equity cost of capital) > expected return on bonds (yield) because shares are riskier.

• Corporate vs. Treasury Bonds:

  • Treasury Bonds: Generally risk-free; repayment of interest and face value is certain.
  • Corporate Bonds: Carry additional risk; repayment of interest and face value is uncertain.
  • Conclusion: Expected return on corporate bonds (corporate bond yield) > expected return on treasury bonds (treasury bond yield) because corporate bonds are riskier.
    Credit Spread: Bonds with lower credit ratings have higher credit spreads.

• Vanguard Diversified ETFs:

  • VDCO (Conservative): 30% growth assets, 70% income assets; minimum timeframe: 3 years; medium risk.
  • VDBA (Balanced): 50% growth assets, 50% income assets; minimum timeframe: 5 years; medium risk.
  • VDGR (Growth): 70% growth assets, 30% income assets; minimum timeframe: 7 years; high to very high risk.
  • VDHG (High Growth): 90% growth assets, 10% income assets; minimum timeframe: 7 years; high to very high risk.

Calculating Historical Rates of Return

• Lecture Example 1: Harvey Norman Limited (HVN.AX)

  • Share price at the beginning of 2024: $4.20$
  • Share price at the end of 2024: $4.67$
  • Dividends received: $0.22$ per share.
  • Calculations:
    • Dividend return: $\frac{0.22}{4.20} = 5.24\%$
    • Capital return: $\frac{4.67 - 4.20}{4.20} = 11.19\%$
    • Total return: $5.24\% + 11.19\% = 16.43\%$.

• General Formula:

  • Buy asset at time $t$ for price $P_t$.
  • Asset pays income from time $t$ to $t+1$.
  • Price of asset at $t+1$ is $P_{t+1}$.
  • Total return formula: $Total\,return<em>{t+1} = \frac{Income</em>{t+1} + P<em>{t+1} - P</em>t}{P<em>t} = \frac{Income</em>{t+1}}{P<em>t} + \frac{P</em>{t+1} - P<em>t}{P</em>t} = Income\,return + Capital\,return$

• Lecture Example 2: Coles Group Limited (COL.AX)

  • Share price at the beginning of 2024: $16.11$
  • Share price at the end of 2024: $18.89$
  • Dividends received: $0.68$ per share.
  • Calculations:
    • Total return: $\frac{0.68 + 18.89 - 16.11}{16.11} = 21.477\%$
    • Income return: $\frac{0.68}{16.11} = 4.221\%$
    • Capital return: $\frac{18.89 - 16.11}{16.11} = 17.256\%$.

• Lecture Example 3: 10-year Treasury Bond

  • Purchase price: $840$
  • Coupon rate: 6% (semi-annually)
  • Sale price one year later (after coupon payment): $920$
  • Calculations:
    • Semi-annual coupon payment: \frac{1,000 × 0.06}{2} = $30
    • Total return: $\frac{2 × 30 + 920 - 840}{840} = 16.667\%$
    • Income return: $\frac{2 × 30}{840} = 7.143\%$
    • Capital return: $\frac{920 - 840}{840} = 9.524\%$.

Determinants of Share Prices and Efficient Markets Hypothesis

• Investor Considerations:

  • Historical returns fluctuate substantially.
  • Should investors put their entire savings in shares, or should they try to time the market?

• Share Price Movements:

  • Share prices tend to increase with good news about future earnings.
  • Share prices tend to decrease with bad news about future earnings.
  • This news can be firm-specific (e.g., earnings announcements, CEO retirement) or market-wide (e.g., economic growth, inflation).
  • Prices rise as investors buy shares based on good information and fall as investors sell on bad information.

• Efficient Markets Hypothesis:

  • Concept: All trading opportunities are fairly priced.
  • Securities prices reflect future expected cash flows and all available information.
  • Efficient market: Available information is fully incorporated into security prices, and returns cannot be predicted.

• Weak-Form Efficient Markets Hypothesis:

  • All past security market information is reflected in security prices.
  • Price and volume information are already reflected in a security’s price.

• Semi-Strong-Form Efficient Markets Hypothesis:

  • All publicly available information is reflected in securities prices.
  • Includes all public information, not just price and volume.

• Strong-Form Efficient Markets Hypothesis:

  • All information (public and private) is reflected in security prices.
  • Encompasses weak-form and semi-strong-form hypotheses.
  • No information is not already embedded in security prices.

Index vs. Actively Managed Funds

• Index Fund:

  • Goal: Match the performance of a specific market benchmark (e.g., S&P/ASX All Ordinaries Index).
  • Strategy: Buy all (or a representative sample) of shares and bonds in the index.
  • Risk: Aligns directly to the risks of the tracked market.
  • Fees: Lower fees.
  • Examples: AMP Australian Equity Index Fund, BlackRock iShares Core A&P/ASX 200 ETF, Vanguard Australian Share Index ETF.

• Actively Managed Fund:

  • Goal: Outperform its benchmark.
  • Strategy: Uses fund manager's research to hand-select shares or bonds.
  • Risk: Includes the risk of manager underperformance.
  • Fees: Higher fees.
  • Examples: Macquarie Australian Shares Fund, Perpetual Australian Share Fund, Wilson Asset Management Leaders Investment Portfolio.