16/12/2019 Use market risk premium for expected market return

TRADING SKILLS & ESSENTIALS RISK MANAGEMENT

Use Market Risk Premium for Expected

Market Return

BY CLAIRE BOYTE-WHITE | Updated Feb 22, 2019

In some cases, brokerage firms provide an expected market rate of return based on an
investor's portfolio composition, risk tolerance, and investing style. Depending on the
factors accounted for in the calculation, individual estimates of the expected market return
rate can vary widely.

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For those who do not use a portfolio manager, the annual return rates of the major indexes
provide a reasonable estimate of future market performance. For most calculations, the
expected market return rate is based on the historic return rate of an index such as the S&P
500, the Dow Jones Industrial Average, or DJIA, or the Nasdaq.

Market Risk Premium

The expected market return is an important concept in risk management because it is used
to determine the market risk premium. The market risk premium, in turn, is part of the
capital asset pricing model, (CAPM) formula. This formula is used by investors, brokers, and
financial managers to estimate the reasonable expected rate of return on a given
investment.

The market risk premium represents the percentage of total returns attributable to the
volatility of the stock market and is calculated by taking the difference between the expected
market return and the risk-free rate. The risk-free rate is the current rate of return on
government-issued Treasury bills (T-bills). Although no investment is truly risk-free,
government bonds and bills are considered almost fail-proof since they are backed by the
U.S. government, which is unlikely to default on financial obligations.

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For example, if the S&P 500 generated a 7% return rate last year, this rate can be used as the
expected rate of return for any investments made in companies represented in that index. If
the current rate of return for short-term T-bills is 5%, the market risk premium is 7% to 5%,
or 2%. However, the returns on individuals stocks may be considerably higher or lower
depending on their volatility relative to the market.

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Related Terms
Risk-Free Return
Risk-free return is the theoretical return attributed to an investment that provides a guaranteed return
with zero risk. The yield on U.S. Treasury securities is considered a good example of a risk-free return.
more

Market Risk Premium

Market risk premium is the difference between the expected return on a market portfolio and the risk-
free rate. it is an important element of modern portfolio theory and discounted cash flow valuation.
more

Equity Risk Premium

Equity risk premium refers to the excess return that investing in the stock market provides over a risk-
free rate. more

How to Use Required Rate of Return – RRR to Evaluate Stocks

The required rate of return (RRR) is the minimum return an investor will accept for an investment as
compensation for a given level of risk. more

Risk
Risk takes on many forms but is broadly categorized as the chance an outcome or investment's actual
return will differ from the expected outcome or return. more

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Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model is a model that describes the relationship between risk and expected
return, helping in the pricing of risky securities. more

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