Explain the return and risk features of equity securities
The idea
Equity return comes from price appreciation and from dividends, and over long horizons equities have delivered higher real returns than bonds or cash together with much higher volatility and deeper drawdowns. The residual nature of the claim explains both: shareholders are paid last, so they absorb the variability that fixed claims are insulated from. Preference shares are less risky than common because their claim is prior and their dividend fixed, and putable shares less risky than ordinary ones. Risk is a consequence of position in the capital structure, not a property of the label.
Formulas
Holding period return on a share
HPR = (P₁ − P₀ + D₁) ÷ P₀
- P₀
- the price at the start
- P₁
- the price at the end
- D₁
- any cash received over the period
Both sources of equity return in one number, on the money actually put up. Leaving the dividend out understates the return by the dividend yield, which over long periods is most of it.
A practice question
What are the two components of return on an equity security?
- Coupon and principal repaymentWhy not: Those are a bond's contractual payments, and a share has neither.
- Price appreciation and dividends — correct
- Interest and capital gainWhy not: Shares pay dividends at the board's discretion rather than interest under a contract.
Equities have no contractual payment. Return is whatever the price does plus whatever the board chooses to distribute.
A harder one
A company's earnings halve. Which of its two classes of shares absorbs more of that?
- The preference shares, whose dividend is largerWhy not: The size of the dividend is not what determines exposure. The preference claim is fixed and prior, so it is the last to be affected.
- Both equally, since both are equityWhy not: The label is shared; the position in the queue is not, and position is what decides who absorbs a shortfall.
- The common shares, because the preference claim is prior and fixed — correct
Risk follows position in the capital structure rather than the name of the instrument.
The hardest tier
Why have equities historically delivered higher real returns than bonds over long horizons?
- Because investors require compensation for bearing the residual, more variable claim — correct
- Because equity dividends are tax exemptWhy not: Dividends are taxed, and tax treatment varies by jurisdiction and investor, so it cannot explain a general excess return.
- Because bond issuers default more often than equity issuersWhy not: Default runs the other way in its effects: a default hurts shareholders first, since they rank behind the bondholders.
The equity risk premium is payment for absorbing variability and for ranking last. It is not a guarantee, and over shorter periods equities have underperformed bonds for decades at a time.
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