What are the Difference among Required, Expected, and Realized Rates of Return in Investing?
The present value of any expected future cash flows is a measure of the value of the cash flows at time zero, the time at which the cash flows are valued. In any present value calculation, the discount rate represents the amount of return for the privilege of “renting” the money invested. However, there are three ways to conceptualize and calculate returns on investment. The required, expected, and realized returns all help an investor make financial decisions.
Required Rate
The required rate of return is the rate that indicates the riskiness of an asset. Essentially, it reflects the riskiness of all future cash flows associated with the investment. To be willing to make the investment, it is the minimum return necessary for an investor to consider buying the asset.
What is often confusing is that the required rate is not in any way tied to each individual investor’s situation. It is based on the conditions of the market. Remember that assets in a capital market are priced by the highest bidder. In any market, sellers exercising financial self-interest always sell to the highest bidder resulting in asset pricing reflecting the highest bidder’s situation and no on else’s. Purchasers of an asset must pay the highest bidder’s price or increase the price themselves in which case the market price is temporarily based on that investor’s situation.
Expected Rate
The expected rate is simply the rate an investor can expect to realize if the investment is made. The expected rate can also be thought of as the rate that would make the Net Present Value of the investment zero. The Net Present Value is zero when the rate of return is exactly in line with the level of risk associated with the investment. The higher the risk, the higher the return must be to compensate for the increased risk taken on by purchasing the asset. When the Net Present Value is zero, the required and expected returns are equal.
Realized Rate
The realized rate is the return actually obtained by buying an asset. It is important to understand that nothing can change a realized return. It is an after-the-fact figure that no amount of behavior can change. A realized return only indicates to the investor information for better future financial decisions.
In efficient capital markets, expected and required returns are equal because all Net Present Values are zero; this means prices are always fair and perfectly represent the risk taken on by buying any asset. Capital markets, however, are not perfect. Events occur that investors could not reasonably predict, weather wipes of crops, and assets tied to foreign currency fluctuate without warning in response to global economic changes. In addition, information lags creating arbitrage opportunities between markets.
It is fundamentally important to understand that realized returns are in no way connected to either required or expected returns. Current technology does not allow investors to go back and make different decisions in the past. Realized returns only allow investors to rethink their own valuation strategies and learn from mistakes.
This post is part of the series: Net Present Value and its Relationship to Return Rates
Net Present Value often confuses because it is a measure of profitability tied to risk, not wealth. Even negative Net Present Value investments can make money; they just don’t make enough given the risk. Additionally, three types of return rates are commonly used to assess returns.
