There are usually three components to an investment’s return; the price you initially pay for the asset, the income you earn over the period you retain an asset and the amount you are able to realise when you sell it. But many investors do not appreciate this.

The ability (with any sense of accuracy) to determine the expected return of the different components varies for each asset class.

Price

The easiest of the factors to determine is the price you pay, because it is known. It follows that any shrewd investor will pay especially close attention to ensuring that the price paid (or entry point) is ideally cheap, or at the very least fair value.

One of the most effective methods to determine this has been to look at the yield on the asset compared to its long-term averages, inflation levels and other asset classes. Historically (and logically) it has been astute to invest at times of high relative yields and damaging to invest when yields are relatively low.

Expected income

The next easiest factor to predict is the income one expects to earn over the period of the investment. For certain asset classes, such as the money market and bonds, this is very easy. For others, such as property, it is trickier, and for equities it is the most challenging. Despite this, one can develop the reasonable assumption for a group of equities (such as the market) that their dividends will grow at slightly less than the sum of real economic growth and inflation.

There is a close link between the first two components as the initial yield is an important element in determining both the initial value and in estimating the likely income to be earned.

Exit price

The final factor, the exit price, is again easy to predict for bonds (if held to maturity) and cash, but much tougher for property and particularly equities.

This is the area that human emotion and sentiment plays the biggest part. Income (in the form of bond coupons, property rentals and equity dividends) does not fluctuate greatly, but market prices do. This is a significant risk for investors with a fixed time period. Importantly, however, for the long-term investor this is not that much concern and can actually be a major advantage.

Importance of factors varies

The importance of each factor also varies in the minds of investors. For example, pensioners often focus predominantly on income, while investors in bubble environments (such as Nasdaq in the late 1990s) pay scant regard to the first two components and place all their chips on the end realisable value. Closer to home, the lofty prices of some residential property and the accompanying low yields are justifiable in the minds of speculators only because of the potential capital gain at the end of the rainbow.

Ignoring the price one pays and the income (or yield) that the asset commands are dangerous mistakes investors consistently make at the top of market cycles. Another is to buy without regard to value in the hope of selling to another at a higher value. That is speculating, not investing.

Nic Andrew is head of Nedgroup Investments.