It makes sense that the cheaper you buy an asset the higher its prospective return will be. However, this is frequently forgotten with investors often tempted to project recent returns into the future regardless of valuations. A valuation measure for an asset is basically a guide to whether it’s expensive or cheap. This note looks at the main issues.
It's relatively easy for cash and bonds…
An obvious example of where the starting point valuation matters critically is cash. If the interest rate on offer from a term deposit rate is relatively high, then that is good because that is precisely the return you will get. For example, 10 years ago average term deposit rates in Australia were over 6%. This was pretty good given inflation was around 2%, so the starting point for term deposits then was attractive. Now term deposit rates are averaging below 0.5% so they are not such good value!