Question

1) Historically, Stocks have returned more than bonds and cash. What is the likely reason for the return differences between cash, fixed income, and equities?

Answer 1

• Cash

Cash is majorly an ideal instrument unless deposited for some Deposits. Cash itself cannot increase. It needs to be invested or deposited. Deposit rates of banks are quite low. And therefore the ideal cash in banks needs to be invested in some fixed income or equities schemes. to get desired return with risks adjustments.

• Equity

Equity investments allow investors to hold partial ownership of issuing companies. As one of the principal asset classes, equity plays a vital role in financial analysis and portfolio management.

Equity investments come in various forms, such as stocks and stock mutual funds. Generally, stocks can be categorized into common stocks and preferred stocks. Common stocks, the securities that are traded most often, grant the owners the rights to claim the issuing company’s assets, receive dividends, and vote at shareholders’ meetings. Preferred stocks, in comparison, offer the same claim on assets and rights to dividends, but do not grant the right to vote.

Dividends are the cash flows of stocks. They are discretionary, meaning that companies are not obligated to pay out dividends to investors. When paid, they are non-tax deductible, and often paid out quarterly. Preferred stock owners are entitled to dividends before common stock owners, although holders of both stocks can only receive dividends after all creditors of the company have been satisfied.

Risks of equity

For investors, equity investments offer relatively higher returns than fixed income instruments. However, the higher returns are accompanied by higher risks, which are made up of systematic risks and unsystematic risks.

Systematic risks are also known as market risks, and refers to the market volatility in various economic conditions.

Unsystematic risks, also called idiosyncratic risks, refer to the risks that depend on the operations of individual companies. Systematic risks cannot be avoided through diversification (i.e. mixing a variety of stocks with distinctive characteristics), while unsystematic risks, on a portfolio level, can be minimized through diversification.

• Fixed Income

A fixed-income security is a security that promises fixed amounts of cash flows at fixed dates. We frequently refer to fixed-income securities as bonds.

We will discuss two types of bonds: zero-coupon bonds and coupon bonds. A zero-coupon bond (or zero) promises a single cash flow, equal to the face value (or par value), when the bond reaches maturity. Zero coupon bonds are sold at a discount to their face value. The return on a zero coupon bond is the difference between the purchase price and the bond’s face value.

A coupon bond, similarly, will also pay out its listed face value upon maturity. Additionally, it also promises a periodic cash flow, or coupon, to be received by the bondholder during their holding period. The coupon rate is the ratio of the coupon to the face value. Coupon payments are typically semi-annual for US bonds and annual for European bonds.

Risks of fixed income securities

Fixed income securities typically have lower risks, which means they provide lower returns. They generally involve default risk, i.e., the risk that the issuer will not meet the cash flow obligations. The only fixed-income securities that involve virtually no default risk are government treasury securities. Treasury securities include treasury bills (that mature in a year), notes (that mature in between 1 and 10 years), and long-term bonds (that mature in more than 10 years).