Question

Please explain the below answer in simple terms:

Q: Explain how are nominal and real returns of equity investment related with inflation
A: Nominal returns of equities are positively related to inflation (0.31) where entirely all of the correlation is between capital gains and inflation, while dividends and inflation are uncorrelated. The real returns of equities are uncorrelated with inflation. This implies that equities are a hedge to inflation that is they are unaffected by inflation.

Answer 1

Answer:

Simple Explanation:

Let us first understand what is nominal return on equities.Nominal Return on Equities refer to return on equities which does not take into account inflation.

On the other hand: Real Return on Equities refer to return on equities after adjusting for inflation.

The Return on Equities comprises of two components:

1. Capital Appreciation or Capital Gains:Rise in the value of a capital asset(investment or real estate)
2. Dividends: A proportion of the company's profits which is given back to the shareholders

Now let us understand the answer in parts:

The first sentence: Nominal returns of equities are positively related to inflation (0.31) .This means that nominal returns of equity will rise with rise in inflation and vice-versa.A 0.31 correlation means that they are moderately correlated ie. for every 1% rise in inflation the nominal returns on equity will rise by.31 percent.

where entirely all of the correlation is between capital gains and inflation:This means that out of the total nominal return on equities only the capital gains part is positively correlated with inflation.Thus the .31 percentage (increase or decrease)movement brought about in the nominal rate of return on equities due to 1% increase or decrease in inflation is totally on account of .31% increase or decrease in capital gains.

while dividends and inflation are uncorrelated: There is no relation between the dividend component of the nominal return on equities and inflation ie. there will be no change in dividend  due to any change in inflation.

The real returns of equities are uncorrelated with inflation: There is no relation between the real return on equities and inflation ie. there will be no change in real return on equities due to changes in inflation.

This implies that equities are a hedge to inflation that is they are unaffected by inflation:Since the real return on equities remain unchanged with inflation so equities can be used to minimize the loss from other investments that are affected by inflation.