Individuals and organizations make investments with expectations of gaining the highest possible return. An investor who takes risk will expect to receive a rate of return that corresponds to the respective level of risk. Required rate of return and expected return represent the levels of return that is to be gained from making risky investments. If these rates of return are not in line with the investor’s previously set benchmark or cut off point, the individual will not consider the investment to be a worthwhile one. The following article provides a clear overview of required return and expected returns and highlights their similarities and differences.
What is Required Return on Investment?
The required rate of return is the return that an investor requires to make an investment in an asset, an investment, or a project. The required rate of return represents the riskiness of the investment being made; the rate of return will reflect the compensation that the investor receives for the risk borne.
The required rate of return is helpful when making decisions regarding the best place for funds to be invested. Required rate of return will differ from one individual/corporation to another. For example, an investor has the option to invest in bonds with a return of 6% per annum. The investor also has the option to invest his funds in a number of other investments. However, the investor’s required rate of return in now 6%, and so the investor expects a return of 6% or higher in order for the other investment options to be considered.
What is Expected Return on Investment?
The expected rate of return is the return that the investor expects to receive once the investment is made. The expected rate of return can be calculated by using a financial model such as the Capita Asset Pricing Model (CAPM), where proxies are used to calculate the return that can be expected from an investment. The expected rate of return can also be calculated by assigning probabilities to the possible returns that can be obtained from the investment.
The expected rate of return is an assumption, and there is no guarantee that this rate of return will be received. However, certain instruments have a set rate of return such as interest on fixed deposits; with such investments, the expected return can be known with a much greater degree to certainty.
What is the difference between Expected Return and Required Return?
Required return and expected return are similar to each other in that they both evaluate the levels of return that an investor sets as a benchmark for an investment to be considered profitable. The required rate of return represents the minimum return that must be received for an investment option to be considered. Expected return, on the other hand, is the return that the investor thinks they can generate if the investment is made. If the security is valued correctly the expected return will be equal to the required return and the net present value of the investment will be zero. However, if the required return is higher than the expected rate the investment security is considered to be overvalued and if the required return is lower than the expected the investment security is undervalued.
Summary:
Expected Return vs Required Return
• The required rate of return is the return that an investor requires to make an investment in an asset, an investment, or a project.
• The required rate of return represents the riskiness of the investment being made; the rate of return will reflect the compensation that the investor receives for the risk borne.
• The expected rate of return is the return that the investor expects to receive once the investment is made.
• The expected rate of return is an assumption, and there is no guarantee that this rate of return will be received, unless the investments are made in instruments have a set rate of return such as interest on fixed deposits.