Public equity
| Real return | Long term average about 4% +- 1%, short term (earnings yield) +- 2% |
| Volatility | 16% +- 2% |
| Correlation | 1, the benchmark |
| Testfolio | VTSIM |
| Inflation | Real, but interest rate sensitive |
Public equity (stocks) is the quintessential asset class. It has high returns and high volatility. Its strong performance, long history and ease of access make it the cornerstone of most portfolios.
Stocks can be classified into sectors and geographical regions, with associated specific risks. These specific risks can be diversified away by holding a well diversified index fund. Market capitalisation weighting is simple and fine. Sector, region or risk weighting might theoretically make more sense, but the difference isn’t very big. Equal weighting stocks doesn’t make sense.
Although the returns of stocks are famously difficult to predict, there seems to be some value in valuation based predicction. The basic idea is that theoretically the price of an asset should be its discounted cash flows. Cash flows can be estimated from current earnings. Then the price is a multiple of the current earnings. The multiplier based on the interest rate, earnings growth rate, and risk premium. If the multiplier is high then future returns might be lower due to two factors:
- The risk premium is lower, so our compensation is less.
- Mean reversion in earnings growth or risk premium.