Having benchmarks and metrics is vital when investing so you can see how you're doing, both in setting your goals and in reaching them. The biggest difference between the required rate of return and the annual return is that one is based on your investment expectations and the other is based on how the investment actually performs -- which could be very different.
Required Return Finance Definition
The required rate of return in finance refers to the minimum return investors expect based on the level of risk presented by an investment. Obviously, a more risky investment will have to promise higher returns, but the required rate of return formula quantifies how much higher it has to be, based on the expected market return, the risk-free rate and the stock's beta (a measure of how volatile the stock is compared to the market in general). To find the required rate of return, subtract the risk-free rate of return from the market return, multiply the result by the investment's beta and add the risk-free rate. For example, say the market return is 5 percent, the beta is 1.3 and the risk-free rate is 2 percent. Subtract 2 percent from 5 percent to get 3 percent. Then multiply 3 percent by 1.3 to get 3.9 percent. Last, add 2 percent to 3.9 percent to find that the required rate of return is 5.9 percent.
Alternative Required Return
The required rate of return measures how much an investment would have to grow for you to meet your investment goals. For example, say you have $15,000, but you want to have $25,000 to help with your child's tuition in six years. The required rate of return measures how much that initial $15,000 investment must increase to reach your goal. Knowing your required rate of return helps you decide how to invest the money. For example, if you know you only need a 3 percent return, you can choose much less risky investments because you simply don't need a higher return. However, if you need a 10 percent return, you might need to pick some investments that could lose money -- like stocks or mutual funds.
Required Return Calculations
To figure the required rate of return, you need your initial investment, your investment goal and the number of years you have to reach your investment goal. First, divide your investment goal by your initial investment to figure the overall required growth factor. Second, raise the overall growth factor to the power of 1/Y, where Y is the number of years you have to reach your investment goal, and then subtract 1 and multiply by 100 to figure required rate of return you need to hit each year. For example, say you need $15,000 to grow to $25,000 in six years. Divide $25,000 by $15,000 to get 1.6667. Then, raise 1.6667 to the 1/6 power to get 1.0889. Finally, subtract 1 to get 0.0889 and multiply by 100 to find that the annual required rate of return is about 8.89 percent.
Annual Return Definition
The annual return of an investment measures how well it actually performed, regardless of how you expected it to do. This metric can serve multiple purposes. If you're picking investments, knowing how the investment has done in the past can help you decide if it's an investment that could generate your required rate of return -- but past performance isn't a guarantee of future gains. Also, measuring the annual return helps you determine whether you're still on track to meet your investment goals. The formula is the same as the formula for calculating the required rate of return, except that instead of plugging in your investment goal, you use the actual value of the investment.
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