Introduction

It’s logical that the cheaper you buy an asset the higher its prospective return might 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 simple 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 low as was the case into early last year when rates were 0.5% or less then it means pretty poor returns. Recently term deposit rates have increased with the RBA cash rate and so are offering a more attractive return potential, albeit they are still down from levels around 6-7% in 2010.

For government bonds in advanced countries the yield is similarly a good guide to starting point value and hence medium-term return potential. Over short-term periods bond prices can move up and down and this influences short term returns, but over the medium term the return a bond investor will get is what bond yields were when they invested. If the yield on a 10-year bond is 5%, and you hold the bond to maturity, your return will be 5%. Of course, the relationship is not perfect but it’s a good guide. This can be seen in the next chart which shows a scatter plot of Australian 10-year bond yields since 1950 (horizontal axis) against subsequent 10 year returns from Australian bonds based on the Composite All Maturities Bond index (vertical axis). Read full article with graphs…