The required rate of return is a subtle concept that involves the opportunity cost of investing. It is the return expected of other investments with the same risk. The required rate of return is the minimum rate an investment must yield to be competitive with other investments on the market. If an investment’s expected returns are lower than other equally risky investments, investors will fund more attractive investments instead.
The capital asset pricing model (CAPM) provides a simple way to calculate the required return of an investment based on its market risk, the risk premiums priced into current markets and the risk-free rate of return. Each of these values can be estimated and combined using addition and multiplication.
U.S. government treasury bonds are used to estimate the risk-free rate. Determine how long you expect to hold your investment, and find a fixed-rate treasury bond that matures in the same time frame. Use the yield of this treasury as an estimate for the risk-free rate of return.
Different investments differ in their risk. The required rate of return reflects the risk that cannot be diversified away in a portfolio. This kind of risk is called market risk, and it is the co-movement of the stock with changes in the securities market. It is estimated by a value called beta, which can be found for stocks on finance Web portals like Yahoo! Finance. Higher beta values imply greater market risk. Beta values can be assigned to investments that are not publicly traded by using beta values from related stocks.
Market Risk Premium
The market risk premium is the expected return of risky investments in excess of the risk-free rate. Historical values are calculated from past stock returns and forward-looking values are calculated from stock market earnings projections and current stock prices. Both historical and forward-looking estimates are frequently calculated and recent estimates can be found by searching for "market risk premium" online.
Required Return Calculation
Calculate the required return of an investment by multiplying its beta and the market risk premium and then adding the risk-free rate. This is the required return of an investment that is part of a liquid, well-diversified investment portfolio. Investing outside of public markets should have higher returns than these calculated values if they are not as liquid as stock market investments or if they are large components of an investor’s portfolio.
- Comstock Images/Comstock/Getty Images