To optimise a company’s profit, the chief financial officer would aim to minimise the weighted average cost of capital used to finance company’s activities. This is the balance between equity finance (shares) and debt finance. There are different kinds of shares based on the rights attached to the shares. As an example, you can give up your voting right for a right to get dividend before any other shareholders. Below is a list of the main types of equity you can invest in, you will note many of these instruments look very similar to a fixed income instrument. This illustrates why both fixed income and equity is a capital asset, you need to beware of limited diversification it offers in times of stressed markets.

Chart 1 above is an illustration of the compounded return you would have gotten if invested into the assets classes. This is actual returns based on an index representing the asset class for a country (USA in this case) over the last ten years.

Equity offered the highest return, followed by listed real estate. Over extended time periods you would expect this return profile. Fixed income and cash offered a much lower return. But the line appears more smooth.

You will notice the lines for equity and property appear more active. The lines move up and down more frequently and in larger moves than cash or fixed income. This is one of the main reason equity is seen as more risky. Equity can have these violent moves. This volatile return profile is linked to uncertainty over future profit share owners of shares are entitled to. Secondly worst-case scenario you will get more from fixed income than equity investments, hence fixed income is seen as a safer investment. 

Chart 1 looked at return over an extended period and grew it on a monthly basis. You would also like to know what if you are invested for a shorter time period? Chart 2 above look at what was the holding period return over various time windows. We took the last 10 years of the index returns and work out what was the return if you invested for the first 12 months. Then we looked at what was the return if you invested for 12 months from the second month to the 13 month. We repeated the process until we looked at the last 12 months. We then calculated the average return for 12 months the first blue star on the chart. We also looked at what was the worst (green block) and best (blue triangle) 12 month window.

We then repeated the process using a 24 months window until we got to a 120 month window. Table 1 below shows the numbers of this exercise.

What is clear from the chart 2 is over the short term say 1 to 2 years you can have a negative return. As your time horizon increases your return increase, as you share in the economic profit of the companies you are invested in. Equity investing is medium to long-term investment.

Chart 4 is a frequency distribution that shows how often a return is generated on a monthly basis. You can see the most frequently occurring values are around 3.5% with 32 observations. This shows most of the returns are larger than 2.5% and less than 4.5%. The second most occurring observations are between 0.5% and 2.5% followed by observations of between 4.5% and 6.5%.
You also notice that the observations are not normally distributed, have a slight skew to the right, hinting at more positive observations than negative ones.
Chart 5 is a cumulative frequency distribution chart which has a steep upward angle. Based on distribution dispersion only around 20% of the time would you expect to get a negative return.