• CPI falls to 2.7pc, boosting investor confidence
  • Lower inflation means higher real returns for stocks
  • Market risk premium and Alpha are also important concepts for investors

 

The CPI

Last Wednesday, the Australian Bureau of Statistics released the latest inflation numbers, showing that Australia’s CPI rate has fallen to 2.7% in August, down from 3.5% in July.

This is the first dip within the RBA’s target band of 2-3%, and the lowest level we’ve seen since 2021.

For stock investors, this is good news because if you want to keep your hard-earned cash from losing its purchasing power, understanding the interplay between stock returns and inflation is crucial.

After all, a decent return might not feel so great if it doesn’t outpace rising prices.

When inflation is low, the stock’s real return – what you actually earn after factoring in inflation – tends to be higher.

Real Return = Nominal Return – Inflation Rate

For instance, if your investments grow by 5.7% and the current inflation rate is 2.7%, your real return would be 3%. This means that when inflation is lower, your returns are effectively higher.

Worth noting that the Nominal Return here refers to the total return of the stock – ie; capital gains and dividends.

 

The MRP

Another important concept for investors is the market risk premium (MRP), which represents the extra return expected from a stock portfolio compared to a risk-free investment, such as government bonds.

Stock investors should aim for higher returns than government bonds because investing in stocks inherently involves greater risk.

The MRP reflects that additional risk that investors assume when they choose to invest in the stock market rather than in safer assets.

Stock investors typically look at the yield on 10-year government bonds when calculating the market risk premium.

The 10-year bond is commonly used because it strikes a balance between short-term and long-term rates, providing a more reliable measure of the risk-free rate over time.

 

Australian 10-year government bond yield

Source: MarketWatch

 

The Alpha

Yet another important concept is called the Alpha return.

Alpha measures how much better or worse a stock performs compared to a benchmark, such as the the SPI ASX200 index benchmark.

It essentially represents the “extra edge” an investment has, so when a stock’s return beats the benchmark index, that’s considered positive alpha.

This measure is important because it helps investors assess how well a portfolio or fund manager is doing compared to simply tracking the overall market.

For many investors and fundies, achieving alpha is the ultimate goal.

Also it’s worth noting that if a portfolio manager charges fees but only achieves a return that matches the market – resulting in zero alpha – investors might actually end up losing money after covering those costs.

 

ASX small caps with the best returns this year so far

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Now read this: ‘Eat well or sleep well?’ – this trading signal helps choose stocks based on your risk tolerance

 

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