Adjusted expected rate of return: Meaning, Criticisms & Real-World Uses

What Is Adjusted Expected Rate of Return?

The adjusted expected rate of return is the anticipated rate of return on an investment or portfolio after accounting for specific factors, most commonly inflation and taxes. This concept is fundamental within portfolio theory, providing investors with a more realistic outlook on their potential earnings in terms of purchasing power. While a simple expected rate of return forecasts growth in nominal terms, the adjusted expected rate of return offers a clearer picture of the real increase in wealth, which is crucial for long-term financial planning and investment decision-making. Investors use this metric to assess whether an investment strategy adequately compensates them for the erosion of purchasing power due to inflation and the impact of taxation.

History and Origin

The concept of adjusting returns for factors like inflation has roots in early economic thought, particularly in the work of Irving Fisher in the early 20th century, who distinguished between nominal and real return rates. Fisher's hypothesis posited that expected asset returns should move in line with expected inflation, implying that real returns are largely determined by non-financial factors such as productivity and time preferences. However, empirical studies have shown that the relationship between stock prices and inflation can be complex and influenced by economic and monetary policy. For instance, research indicates that financial markets interpret inflation differently depending on the perceived monetary policy regime, affecting the relationship between stock returns and expected inflation.⁴ The practical application of adjusted expected rates of return became increasingly important with the rise of modern risk management and portfolio optimization techniques, particularly as inflation became a more volatile factor in global economies.

Key Takeaways

The adjusted expected rate of return accounts for factors like inflation and taxes to provide a realistic view of investment growth.
It is critical for evaluating the true increase in purchasing power from an investment.
Understanding this rate helps in long-term financial planning and setting appropriate investment goals.
Adjustments are essential for comparing diverse investment opportunities on a consistent basis.

Formula and Calculation

The most common adjustment for the expected rate of return involves subtracting the expected inflation rate to arrive at the real expected return. If taxes are also considered, the formula becomes more comprehensive.

The general formula for the real adjusted expected rate of return, considering inflation, is:

R_{real, expected} = \frac{1 + R_{nominal, expected}}{1 + I_{expected}} - 1

Where:

(R_{real, expected}) = Adjusted Expected Rate of Return (real)
(R_{nominal, expected}) = Expected Nominal return
(I_{expected}) = Expected Inflation Rate

For a post-tax, real adjusted expected rate of return, the formula expands:

R_{post-tax, real, expected} = \frac{1 + (R_{nominal, expected} \times (1 - T))}{1 + I_{expected}} - 1

Where:

(T) = Expected Tax Rate on Investment Returns

This calculation provides insight into the actual increase in wealth after accounting for the eroding effects of rising prices and taxation. Investors often compare this rate to a risk-free rate to determine if the expected compensation for bearing risk is adequate.

Interpreting the Adjusted Expected Rate of Return

Interpreting the adjusted expected rate of return involves understanding its implications for an investor's purchasing power and long-term financial health. A positive adjusted expected rate of return indicates that an investment portfolio is expected to grow faster than inflation and taxes, thus increasing the investor's real wealth. Conversely, a negative adjusted expected rate of return implies that the investment's growth will not keep pace with the combined effects of inflation and taxes, leading to a decrease in purchasing power over time, even if the nominal return is positive.

This metric is particularly vital for evaluating different asset allocation strategies and understanding the true potential of an investment. For example, a bond yielding a 5% nominal return might seem attractive, but if inflation is expected to be 3% and taxes consume 20% of the nominal return, the real post-tax adjusted expected rate of return would be significantly lower, potentially eroding wealth. The Securities and Exchange Commission (SEC) emphasizes that all investments carry some degree of risk, and generally, higher risks are taken in pursuit of higher returns.³ An adjusted expected rate of return helps assess if the anticipated reward justifies the inherent risks, especially in environments with persistent or fluctuating inflation expectations.

Hypothetical Example

Consider an investor, Sarah, who is evaluating two potential investments for her retirement fund:

Investment A (Growth Stock Fund): Expected nominal return of 9% per year.
Investment B (Dividend Stock Fund): Expected nominal return of 6% per year.

Sarah anticipates an average inflation rate of 3% annually over her investment horizon. She is in a tax bracket where her investment gains are taxed at 15%.

Let's calculate the adjusted expected rate of return (post-tax, real) for both:

For Investment A (Growth Stock Fund):

Expected nominal return: (R_{nominal, expected}) = 0.09
Expected inflation rate: (I_{expected}) = 0.03
Expected tax rate: (T) = 0.15

R_{post-tax, real, expected, A} = \frac{1 + (0.09 \times (1 - 0.15))}{1 + 0.03} - 1

R_{post-tax, real, expected, A} = \frac{1 + (0.09 \times 0.85)}{1.03} - 1

R_{post-tax, real, expected, A} = \frac{1 + 0.0765}{1.03} - 1

R_{post-tax, real, expected, A} = \frac{1.0765}{1.03} - 1

R_{post-tax, real, expected, A} \approx 1.0451 - 1 \approx 0.0451 \text{ or } 4.51\%

For Investment B (Dividend Stock Fund):

Expected nominal return: (R_{nominal, expected}) = 0.06
Expected inflation rate: (I_{expected}) = 0.03
Expected tax rate: (T) = 0.15

R_{post-tax, real, expected, B} = \frac{1 + (0.06 \times (1 - 0.15))}{1 + 0.03} - 1

R_{post-tax, real, expected, B} = \frac{1 + (0.06 \times 0.85)}{1.03} - 1

R_{post-tax, real, expected, B} = \frac{1 + 0.051}{1.03} - 1

R_{post-tax, real, expected, B} = \frac{1.051}{1.03} - 1

R_{post-tax, real, expected, B} \approx 1.0204 - 1 \approx 0.0204 \text{ or } 2.04\%

In this scenario, Investment A, despite its higher nominal return, provides a significantly higher real, post-tax adjusted expected rate of return (4.51%) compared to Investment B (2.04%). This calculation helps Sarah understand which investment is likely to offer a greater increase in her purchasing power for her future value needs.

Practical Applications

The adjusted expected rate of return is a critical tool across various facets of finance and investing:

Long-Term Financial Planning: Individuals and financial advisors use the adjusted expected rate of return to project the growth of savings and investments for long-term goals like retirement, education, or purchasing a home. By accounting for inflation, they can determine if projected future value amounts will actually provide the desired purchasing power.
Portfolio Management: Fund managers and institutional investors apply this concept to compare different assets and strategies. It helps them build diversified investment portfolios that aim to achieve specific real return targets, rather than just nominal gains. This is especially relevant when assessing assets with varying tax treatments or inflation sensitivities.
Capital Budgeting: Businesses use the adjusted expected rate of return when evaluating potential projects or investments. They often adjust their required discount rate for inflation and other factors to ensure that a project's expected cash flows will generate a real economic profit.
Economic Analysis: Economists and policymakers monitor aggregate adjusted expected rates of return to gauge the health of the economy and the effectiveness of monetary and fiscal policies. Inflation expectations play a significant role in monetary policy decisions.²
Retirement Planning: Retirees or those nearing retirement need to understand their adjusted expected rate of return to ensure their nest egg will last throughout their lives, given rising living costs. Discussions among investors, such as those on Bogleheads forums, often highlight the importance of realistic future return expectations in financial planning.¹

Limitations and Criticisms

While the adjusted expected rate of return offers a more realistic perspective than a simple nominal return, it comes with inherent limitations and criticisms:

Reliance on Estimates: The primary limitation is its dependence on expected future inflation rates and tax rates, which are inherently uncertain. Inflation can be volatile and difficult to predict accurately over long periods. Similarly, tax laws can change. This uncertainty means the "adjusted" rate is still an estimate and may differ significantly from the actual real return realized.
Behavioral Biases: Investor expectations can be influenced by recent market performance or personal biases, leading to over-optimistic or overly pessimistic forecasts for future returns and inflation. This can lead to an inaccurate adjusted expected rate of return and poor investment decisions.
Simplification of Tax Effects: The calculation often assumes a single, static tax rate, which may not reflect the complexity of progressive tax systems, different tax treatments for various types of income (e.g., capital gains vs. dividends), or changes in an investor's tax bracket over time.
Ignores Other Risks: While adjusting for inflation and taxes, the metric might not explicitly incorporate other forms of risk, such as market risk, liquidity risk, or credit risk. A high adjusted expected rate of return might still correspond to a very risky investment.
Efficient Market Hypothesis: Some financial theories, like the Efficient-market hypothesis (EMH), suggest that it is impossible to consistently "beat the market" on a risk-adjusted basis because asset prices already reflect all available information. While the EMH doesn't negate the calculation of an adjusted expected return, it implies that persistently achieving a high, positive adjusted expected return above what is commensurate with risk is challenging.

Adjusted Expected Rate of Return vs. Real Rate of Return

The terms "Adjusted Expected Rate of Return" and "Real Rate of Return" are closely related but refer to different aspects of investment analysis, particularly concerning timing and certainty.

Feature	Adjusted Expected Rate of Return	Real Rate of Return
Nature	Forward-looking (an estimate)	Historical or achieved (actual, realized)
Primary Adjustment	Forecasted inflation and/or taxes	Actual inflation (and/or taxes, if specified as "real after-tax return")
Purpose	Planning, forecasting, decision-making	Performance measurement, historical analysis
Certainty	Subject to uncertainty and estimation error	Based on known past data
Application Context	Pre-investment analysis, goal setting	Post-investment evaluation, benchmark comparison

The adjusted expected rate of return is what an investor hopes or predicts to earn in real terms before committing capital. It's a key input for prospective decision-making, helping to set realistic expectations for economic growth of wealth. The real rate of return, by contrast, is the actual return achieved after factoring in the inflation that occurred over the investment period. It's a measure of past performance, reflecting the true growth of purchasing power that was already realized. While the former guides future actions, the latter provides feedback on past effectiveness.

FAQs

Q1: Why is it important to adjust the expected rate of return?

A1: It's important to adjust the expected rate of return because inflation erodes the purchasing power of money over time, and taxes reduce the net gains from investments. A nominal return alone can be misleading, as it doesn't reflect the true increase in your wealth or how much you can actually buy with your investment gains. Adjusting for these factors provides a more realistic understanding of potential growth. This helps in making informed investment decisions and setting achievable financial goals.

Q2: How does inflation impact the adjusted expected rate of return?

A2: Inflation reduces the real value of future returns. A higher expected inflation rate will lead to a lower adjusted expected rate of return, assuming the nominal expected return remains constant. This means that if inflation is high, your investments need to generate a much higher nominal return just to maintain their purchasing power. This highlights the importance of considering inflation when evaluating long-term investments.

Q3: Are taxes always included in the adjusted expected rate of return calculation?

A3: Taxes are often included, especially when calculating the "real after-tax expected rate of return," to provide the most precise view of net gains. However, some analyses might only adjust for inflation to derive a "real pre-tax expected rate of return." The specific inclusion of taxes depends on the purpose of the analysis and the tax implications relevant to the investor's situation. Understanding tax efficiency is a critical component of effective financial planning.

Q4: Can the adjusted expected rate of return be negative?

A4: Yes, the adjusted expected rate of return can be negative. This occurs when the expected nominal return of an investment is lower than the combined rate of expected inflation and the impact of taxes. A negative adjusted expected rate of return indicates that an investment is projected to lose purchasing power over time, even if it shows a positive nominal gain.

Q5: How does this concept relate to the Capital Asset Pricing Model (CAPM)?

A5: The Capital Asset Pricing Model (CAPM) calculates the expected return of an asset given its systematic risk (beta) and the market's expected return, above the risk-free rate. While CAPM provides a nominal expected return, the adjusted expected rate of return takes this a step further by incorporating factors like inflation and taxes, offering a real, post-adjustment outlook that aligns with an investor's actual purchasing power objectives. Performance metrics like the Sharpe Ratio also consider risk-adjusted performance but typically use historical data and a risk-free rate, rather than explicitly adjusting for inflation and taxes in a forward-looking "expected" context.