Expected Return vs. Required Return

Attribute	Expected Return	Required Return
Risk	Uncertain, can be positive or negative	Considered in determining the minimum acceptable return
Calculation	Based on probability-weighted average returns	Determined by the investor's required rate of return
Objective	To estimate the potential gain or loss	To meet the investor's expectations and compensate for risk
Time Horizon	Short-term or long-term	Usually long-term
Subjectivity	Objective, based on historical data and future projections	Subjective, influenced by investor's risk tolerance and market conditions
Use in Decision Making	Helps in evaluating investment opportunities	Used to determine if an investment meets the required rate of return

Introduction

When it comes to investing, understanding the concepts of expected return and required return is crucial. These two attributes play a significant role in decision-making processes, risk assessment, and portfolio management. While they are related, they have distinct characteristics that differentiate them from each other. In this article, we will explore the attributes of expected return and required return, highlighting their importance and how they impact investment strategies.

Expected Return

Expected return refers to the anticipated gain or loss an investor can expect from an investment over a specific period. It is calculated by multiplying the potential return of each possible outcome by its respective probability and summing them up. Expected return provides investors with an estimate of the average return they can anticipate based on historical data, market trends, and other relevant factors.

One of the key attributes of expected return is that it is a forward-looking measure. It takes into account the potential gains and losses of an investment, allowing investors to assess the potential profitability of a particular asset or portfolio. By considering the expected return, investors can make informed decisions about whether to invest in a specific asset or diversify their portfolio to achieve their financial goals.

Furthermore, expected return is an essential tool for risk assessment. It helps investors evaluate the potential volatility and uncertainty associated with an investment. By comparing the expected return of different assets, investors can determine which investments offer a higher potential return for a given level of risk. This information is crucial for constructing a well-balanced portfolio that aligns with an investor's risk tolerance and investment objectives.

Additionally, expected return is influenced by various factors such as economic conditions, market trends, company performance, and geopolitical events. These factors can impact the probability of different outcomes and, consequently, the expected return of an investment. Therefore, it is essential for investors to stay informed about these factors and regularly reassess their expected return calculations to adapt to changing market conditions.

In summary, expected return is a forward-looking measure that estimates the average return an investor can anticipate from an investment. It helps investors make informed decisions, assess risk, and construct well-balanced portfolios.

Required Return

Required return, also known as the hurdle rate or target rate of return, represents the minimum return an investor expects to achieve to justify the risk associated with an investment. It is the return necessary to compensate for the time value of money, inflation, and the level of risk taken. Required return is subjective and varies among investors based on their risk tolerance, investment goals, and market conditions.

One of the key attributes of required return is that it is a backward-looking measure. It takes into account the investor's desired outcome and the level of risk they are willing to accept. Required return is often used as a benchmark to evaluate the potential profitability of an investment opportunity. If the expected return of an investment is lower than the required return, it may not be considered a viable option for the investor.

Moreover, required return is influenced by various factors such as the investor's time horizon, investment objectives, and risk appetite. Investors with a longer time horizon or higher risk tolerance may have a higher required return, as they are willing to accept more volatility and uncertainty in pursuit of higher potential returns. On the other hand, investors with a shorter time horizon or lower risk tolerance may have a lower required return, as they prioritize capital preservation and stability.

Additionally, required return is an essential tool for evaluating investment opportunities and making capital allocation decisions. By comparing the expected return of an investment with the required return, investors can determine whether the potential return justifies the risk taken. If the expected return exceeds the required return, the investment may be considered attractive. However, if the expected return falls short of the required return, the investor may opt for alternative investment opportunities or adjust their risk tolerance.

In summary, required return represents the minimum return an investor expects to achieve to justify the risk associated with an investment. It is a backward-looking measure that varies among investors based on their risk tolerance, investment goals, and market conditions.

Comparison

While expected return and required return are related concepts in the field of finance, they have distinct attributes that differentiate them from each other. Let's compare these attributes:

1. Time Perspective

Expected return is a forward-looking measure that estimates the average return an investor can anticipate from an investment. It considers potential gains and losses based on historical data, market trends, and other relevant factors. On the other hand, required return is a backward-looking measure that represents the minimum return an investor expects to achieve to justify the risk associated with an investment. It takes into account the investor's desired outcome and the level of risk they are willing to accept.

2. Calculation Method

Expected return is calculated by multiplying the potential return of each possible outcome by its respective probability and summing them up. It provides investors with an estimate of the average return they can expect. On the contrary, required return is subjective and varies among investors. It is determined based on the investor's risk tolerance, investment goals, and market conditions. There is no specific formula for calculating required return as it depends on individual preferences and circumstances.

3. Purpose

Expected return is primarily used to make informed investment decisions, assess risk, and construct well-balanced portfolios. It helps investors evaluate the potential profitability of an investment and compare different investment opportunities. On the other hand, required return is used as a benchmark to evaluate the potential profitability of an investment opportunity. If the expected return of an investment is lower than the required return, it may not be considered a viable option for the investor.

4. Influence Factors

Expected return is influenced by various factors such as economic conditions, market trends, company performance, and geopolitical events. These factors impact the probability of different outcomes and, consequently, the expected return of an investment. On the contrary, required return is influenced by factors such as the investor's time horizon, investment objectives, and risk appetite. It varies among investors based on their individual preferences and circumstances.

5. Risk Assessment

Expected return is an essential tool for risk assessment. It helps investors evaluate the potential volatility and uncertainty associated with an investment. By comparing the expected return of different assets, investors can determine which investments offer a higher potential return for a given level of risk. On the other hand, required return is used to justify the risk associated with an investment. It represents the minimum return an investor expects to achieve to compensate for the level of risk taken.

Conclusion

Expected return and required return are two important attributes in the field of finance that help investors make informed decisions, assess risk, and construct well-balanced portfolios. While expected return is a forward-looking measure that estimates the average return an investor can anticipate from an investment, required return is a backward-looking measure that represents the minimum return an investor expects to achieve to justify the risk associated with an investment. Understanding the differences between these attributes is crucial for successful investment management and achieving financial goals.