Question

Asset Class US Government T-Bill Large Cap Common Stock Long Term Corporate Bond Small Cap Stock Return % 3% 12% 6% 14% Illustrate your understanding as to why asset classes in the above scenario differs in return. What are the most critical variables that is going to likely affect these investment return.

Answer 1

First of all let's start with US government T-Bills it just provide you 3% return still people invest in it why?? Why people don't go for any other investment avenues that provide higher return than that.

The main reason is this return is free from all types of risk first thing is time higher the investment horizon the better the return should be because investor holding his investment for longer periods and foregone any other alternatives so he must receive better return than short term Treasury Bills. this additional return is called Liquidity premium. that is why Long term corporate bond have higher return than Treasury bills.

Than now another question arises if the time Is matter than why the Return from bond and Large cap stock is different both are Long term investment still why they having different return. The reason is equity is more risky than bond because of that reason stocks are having more return than bond. And such additional return is called Equity Premium.

Now another question arises if small cap and Large cap both are stocks still they are having different returns why?

The reason is small cap shares are more volatiles and have higher chances of Default that is why small cap have higher return than Large cap stock. This additional return is called Default risk Premium.

That means return on small cap includes:-

risk free rate + Liquidity premium+Equity Premium+Default risk Premium.

I hope my efforts Will be fruitful to you....?