Adjusted expected return

What Is Adjusted Expected Return?

Adjusted expected return refers to the anticipated rate of return on an investment or portfolio that has been modified to account for specific factors, such as risk, inflation, taxes, or other unique considerations. While a basic expected return calculation estimates a future outcome based on historical data or probabilistic scenarios, the adjusted expected return refines this projection to offer a more realistic or relevant perspective for investment analysis and portfolio management. This concept is fundamental to the broader field of portfolio theory, providing investors with a more nuanced measure than a simple forecast. It is especially vital when evaluating a risk-adjusted return to determine if the potential compensation justifies the inherent risks.

History and Origin

The concept of expected return has roots in classical financial economics, evolving significantly with the advent of modern portfolio theory in the mid-20th century. However, as financial markets grew in complexity and empirical observations highlighted deviations from theoretical models, the need for "adjustments" became evident. Early models, like the capital asset pricing model (CAPM), provided a framework for linking risk and expected return. However, these models often made simplifying assumptions that did not fully capture real-world complexities such as varying transaction costs, differing tax implications, or behavioral biases. The idea of adjusting expected returns gained traction as academics and practitioners sought to integrate these real-world elements into their financial models. Research on how various factors impact investment outcomes, including volatility, has been a continuous area of study within financial theory.⁴

Key Takeaways

• Adjusted expected return is a modified forecast of an investment's future return, accounting for factors beyond a simple historical average or probabilistic estimate.
• Common adjustments include those for risk, inflation, taxes, liquidity, and specific market conditions.
• It provides a more realistic basis for investment decision-making, helping investors compare opportunities on an "apples-to-apples" basis.
• The calculation methods vary depending on the factors being adjusted for, often starting with a basic expected return and applying specific deductions or additions.
• While more comprehensive, adjusted expected returns are still projections and do not guarantee actual performance.

Formula and Calculation

The specific formula for adjusted expected return varies widely depending on the factors being incorporated. Conceptually, it begins with a baseline expected return and then applies adjustments.

A generalized representation can be:

For example, when adjusting for inflation and a specific risk premium, the formula might look like:

Where:

• Nominal Expected Return: The expected return before accounting for inflation or specific risk. This could be derived from historical averages or future forecasts.
• Inflation Rate: The anticipated rate of price increase over the investment period. Adjusting for inflation provides a real rate of return.
• Risk Premium: An additional return expected as compensation for taking on a particular type of risk not fully captured by the nominal expected return (e.g., liquidity risk, sovereign risk).

Other adjustments might involve deducting an estimated discount rate or adding a behavioral bias factor.

Interpreting the Adjusted Expected Return

Interpreting the adjusted expected return involves understanding the specific adjustments made and their implications for an investor's goals. For instance, an inflation-adjusted expected return reveals the purchasing power gain an investor can anticipate, which is crucial for long-term financial planning. A risk-adjusted expected return helps determine if an investment's potential reward adequately compensates for the level of risk tolerance an investor is willing to bear.

This metric helps investors in asset allocation decisions by allowing for a more accurate comparison of diverse investment opportunities, even those with different risk profiles or tax implications. A higher adjusted expected return, after considering all relevant factors, generally indicates a more attractive investment opportunity. However, these adjustments inherently involve assumptions, meaning the interpretation should always be viewed within the context of those assumptions and prevailing market conditions.

Hypothetical Example

Consider an investor evaluating a potential investment in a new energy fund. The fund's management projects a nominal expected return of 9% per year based on their financial modeling. However, the investor wants to account for potential factors that might erode this return.

Let's say the investor estimates:

• Annual inflation: 3%
• Expected management fees and other recurring expenses: 1%
• A specific "new technology risk" adjustment, reflecting the uncertainty of the sector: -0.5% (a deduction, as it represents a perceived additional hurdle or higher required return to compensate).

The calculation for the adjusted expected return would be:

Nominal Expected Return: 9%
Less: Inflation: 3%
Less: Fees/Expenses: 1%
Less: New Technology Risk Adjustment: 0.5%

Adjusted Expected Return = 9% - 3% - 1% - 0.5% = 4.5%

This 4.5% adjusted expected return provides a more conservative and realistic view of the fund's potential profitability from the investor's perspective, reflecting what they might actually gain in terms of purchasing power after all relevant costs and specific risks are considered. This allows for a more informed decision and helps in achieving proper diversification by evaluating investments on a comparable, "real" basis.

Practical Applications

Adjusted expected return is a critical metric across various facets of finance. In institutional investing, portfolio managers use it to compare investment opportunities with different characteristics and to optimize asset allocation strategies. For example, a pension fund might adjust expected returns for long-term liabilities and inflation to ensure they can meet future obligations.

In corporate finance, businesses might use adjusted expected returns when evaluating capital projects, discounting future cash flows to reflect specific project risks or market volatility. Regulatory bodies also influence how expected returns are presented. The U.S. Securities and Exchange Commission (SEC), for instance, has rules regarding the presentation of investment performance by advisers, often requiring the clear disclosure of gross versus net returns, which inherently leads to an adjustment for fees and expenses in public communications.³ This highlights the importance of transparently presenting adjusted expected returns to investors. Furthermore, global economic forecasts from organizations like the International Monetary Fund (IMF) provide crucial context for adjusting expected returns for macroeconomic factors and economic factors like projected global growth or inflation.²

Limitations and Criticisms

Despite its utility, adjusted expected return is not without limitations. A primary criticism is the inherent subjectivity involved in determining the "adjustment" factors. Estimating future inflation, tax rates, or the precise value of a risk premium can be challenging and prone to error or bias. Different methodologies for making these adjustments can lead to significantly varied results, complicating direct comparisons between investments or analyses performed by different entities.

Furthermore, adjusted expected returns, like all forward-looking estimates, are based on assumptions that may not hold true in an unpredictable future. Unforeseen market shifts, policy changes, or geopolitical events can drastically alter actual returns, rendering even the most carefully adjusted projections inaccurate. For instance, research from the Federal Reserve Bank of St. Louis highlights how policy instability can dramatically alter the risk-return trade-off for investors, demonstrating the difficulty of perfectly forecasting and adjusting for such real-world complexities.¹ Concepts from behavioral finance also suggest that investor psychology can lead to irrational decisions that deviate from what rational models, even adjusted ones, might predict.

Adjusted Expected Return vs. Expected Return

The distinction between adjusted expected return and expected return lies in the level of refinement and the specific factors considered. Expected return, in its simplest form, represents the average anticipated outcome of an investment based on historical data or a probability-weighted average of possible future scenarios. It provides a baseline forecast of what an investor might typically expect to gain or lose.

Adjusted expected return takes this foundational figure and modifies it to incorporate additional, often crucial, real-world considerations. These adjustments could include deducting projected fees and taxes, accounting for the impact of inflation (to arrive at a real return), or adding/subtracting a premium or discount for specific risks like illiquidity or political instability. While a raw expected return offers a general outlook, the adjusted expected return provides a more tailored and comprehensive assessment, aiming to reflect the true net gain or loss that an investor can anticipate after all relevant costs, risks, and economic realities are factored in. The former is a theoretical average; the latter is a practical, more realistic projection.

FAQs

Why is it important to use adjusted expected return?

It is important because it provides a more realistic and comprehensive view of an investment's potential performance by accounting for real-world factors that can impact actual returns, such as inflation, taxes, fees, and specific risks. This allows for better investment analysis and more informed decision-making.

What factors can be used to adjust expected returns?

Common factors for adjustment include inflation, taxes, management fees, liquidity risk, credit risk, geopolitical risk, and specific industry or market conditions. The choice of factors depends on the investor's individual circumstances and the nature of the investment.

Does adjusted expected return guarantee actual returns?

No, the adjusted expected return is a forward-looking projection based on assumptions and models, not a guarantee. Actual returns can differ significantly due to unforeseen market movements, economic factors, or changes in the underlying assumptions.

How does adjusted expected return relate to risk?

Adjusted expected return often incorporates risk adjustments, providing a risk-adjusted return that indicates whether the potential compensation justifies the level of risk taken. This is a core component of portfolio management as investors seek to optimize return for a given level of risk.

Can adjusted expected return be negative?

Yes, it can be negative. If the anticipated costs, risks, or other adjustments outweigh the nominal expected return, the adjusted expected return will be a negative figure, indicating an expected loss of purchasing power or a net negative outcome.