Investment terminology can be difficult to navigate, but it doesn’t have to be. If you’re wondering what the difference between an expected rate of return and a required rate of return is, you’ve come to the right place. Essentially, the required rate of return helps you decide if an investment is worth the cost, and an expected rate of return helps you figure out how much you can reasonably expect to make from that investment.
Required Rate of Return
Before investing your money, you probably want to know whether you’re making a good investment or a bad one. This is the main purpose of a required rate of return. The RRR represents the absolute minimum return on investment you would accept for that investment to be worthwhile.
If you need a 4 percent return on your money to make your investment advantageous, then this is your RRR. Any investment you take on should churn out a profit that’s above your RRR. For example, if your RRR is 4 percent and the investment returns 2 percent, then you probably want to skip it.
RRR and Risk
When making an investment decision, it’s important to factor in risk and market volatility. This is because risk-free investments are available through the U.S. government in the form of securities, such as bonds. For an investment to truly be worth the risk, it should substantially outperform the risk-free securities offered by the government. Calculating RRR should take into account several factors, including the volatility of the stock in question, how much you could earn from a risk-free investment and the return of the market as a whole.
Expected Rate of Return
An expected rate of return is the return on investment you expect to collect when investing in a stock. So, for comparison purposes, the RRR is the minimum possible rate that would entice you to invest, and the expected rate of return is what you actually plan to make from that investment. This rate is calculated based on probability.
The truth is, in a volatile market it’s impossible to know what the exact rate of return will be on an investment. However, using information on the stock’s history, its volatility and its overall market returns, you can reasonably estimate what the rate of return will be over a period of time. This is the expected rate of return: what you actually think you might make back on your investment.
ERR and Risk
It’s important to understand that even if you go to great pains to calculate your expected rate of return and include all pertinent risk factors, there are no guarantees. A stock with a volatile price history will be a risk no matter how your calculations come out. RRR and expected rate of return are guiding principles, not predictors of investment success.
Further, different investors have their own individual ways of calculating RRR and expected rates of return. There is no one right way to calculate these numbers. Each person’s investment needs will vary.