Tuesday, September 11th, 2007
A cool equation to help analyse market risk
Conventional wisdom says market timing is impossible. I don’t agree; it’s tough calling bottoms and tops exactly, but analysing market risk and adjusting exposure is possible.
Another tool I’ve come across to help analyse broader market risk is the Gordon equation, which allows investors to roughly calculate the expected return of the market in the long term (30 years +).
William Berstein highlighted the equation in his book, 
The Four Pillars of Investing. A google search doesn’t provide many good references about it. But the equation was pioneered by University of Toronto professor Myron Gordon.
Basically it rearranges Irving Fisher’s ‘discounted dividend model’, which says a share is worth the present value of its future income stream.
The equation is simple: Market return = dividend yield + dividend growth.
If the market dividend yield is, for example, 4 per cent and compounded dividend growth rate was also 4 per cent, then expected long-term return is 8 per cent.
“The Gordon equation is as close to being physical law, like gravity or planetary motion, as we will ever encounter in finance,” Bernstein said.
Slot in the figures for your country. If you assuming a bond’s long-term market returns is the coupon rate, you can then compare it with expected returns from equities and adjust your portfolio accordingly.
A central message from the equation is that after strong market gains, expected returns fall. That may seem obvious, but it’s easily forgotten.
This entry was posted on Tuesday, September 11th, 2007 at 9:31 am and is filed under Market direction, Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
