Expected market return

What Is Expected Market Return?

Expected market return represents the anticipated rate of return an investor believes a particular market or asset class will generate over a specified future period. It is a forward-looking estimate, distinct from past performance, and forms a cornerstone of portfolio theory, guiding investors in making informed decisions about asset allocation and investment strategy. This projection helps individuals and institutions evaluate potential investment opportunities, assess associated risk, and determine if an asset's potential future gains justify its acquisition. Expected market return is a crucial input for various financial models, including those used in valuation and capital budgeting.

History and Origin

The concept of expected market return has evolved alongside modern financial economics. Early theories, such as the Capital Asset Pricing Model (CAPM), developed independently by William Sharpe, John Lintner, and Jan Mossin in the 1960s, provided a foundational framework for understanding how investors might expect to be compensated for taking on systematic risk. CAPM introduced the idea of a linear relationship between expected return and beta, a measure of an asset's sensitivity to overall market movements.

Over time, subsequent research expanded upon these initial models. Notable contributions include the work of Eugene Fama and Kenneth French, who in the early 1990s introduced multi-factor models that proposed additional factors beyond market beta, such as company size and book-to-market equity, to explain variations in expected returns. Their research, examining risk premiums, has significantly influenced how practitioners and academics conceptualize the drivers of expected market return.⁵

Key Takeaways

• Expected market return is a forward-looking estimate of an investment's future profitability.
• It is a critical component in investment decision-making, helping investors compare opportunities and manage risk.
• The estimation involves considering various factors, including historical data, current economic conditions, and future outlooks.
• Expected market return differs from historical market return, which is a backward-looking measure of past performance.
• Accurate forecasting is challenging due to inherent market complexities and unpredictable events.

Formula and Calculation

While there isn't a single universal formula for expected market return, it is often estimated using various models. One widely recognized framework is the Capital Asset Pricing Model (CAPM), which calculates the expected return of an individual asset (or, in a broader sense, the market if viewed as a single asset) based on its sensitivity to market risk.

The CAPM formula is expressed as:

Where:

• (E(R_i)) = Expected return of asset i (or the market in aggregate)
• (R_f) = Risk-free rate (e.g., the yield on a short-term government bond)
• (\beta_i) = Beta (finance) of asset i (a measure of its systematic risk relative to the market)
• (E(R_m)) = Expected return of the overall market
• ((E(R_m) - R_f)) = Equity risk premium (the expected return of the market in excess of the risk-free rate)

Another common approach for estimating the expected market return, particularly for a broad market index, involves combining expected earnings growth with the current dividend yield, sometimes referred to as the Gordon Growth Model approach for market returns.

Interpreting the Expected Market Return

Interpreting the expected market return involves understanding its context and the assumptions underpinning its calculation. A higher expected market return suggests a greater potential for future gains, but it often corresponds to higher perceived risk. Investors use this metric to determine if an investment meets their required rate of return, considering their individual risk tolerance and financial goals.

For instance, if an investor's required return for a particular investment is 8%, and the estimated expected market return for that asset class is 7%, the investment might be deemed unattractive. Conversely, an expected market return of 10% for the same asset class might make it appealing. It's crucial to compare the expected market return against appropriate benchmarks and other investment opportunities, while also factoring in inflation, which erodes purchasing power. The Federal Reserve, for example, publishes summaries of its economic projections, which can offer insights into the broader economic outlook that influences expected market returns.⁴

Hypothetical Example

Consider an investor, Sarah, who is evaluating investing in a broad market index fund. She wants to estimate the expected market return for the coming year.

1. Risk-Free Rate ((R_f)): Sarah finds that the current yield on 3-month U.S. Treasury bills (a proxy for the risk-free rate) is 5%.
2. Market Beta ((\beta_i)): Since she's looking at a broad market index fund, its beta relative to the overall market is approximately 1.0.
3. Expected Market Return ((E(R_m))): To estimate the overall market's expected return for the equity risk premium calculation, she reviews various sources, including macroeconomic forecasts and asset management outlooks like the J.P. Morgan Guide to the Markets, which might offer insights into anticipated corporate earnings and overall economic growth.³ She concludes that the consensus for the broader market's expected return is around 10%.

Using the CAPM formula, Sarah calculates the expected return for her index fund:

Based on this calculation, Sarah's expected market return for her index fund for the next year is 10%. This helps her in her portfolio management decisions.

Practical Applications

Expected market return plays a vital role across various aspects of finance:

• Portfolio Construction: Investors use expected market return to allocate assets strategically, seeking to balance potential returns with acceptable risk levels. It guides the weighting of different asset classes within a diversification strategy.
• Performance Benchmarking: Expected market return serves as a benchmark against which actual investment performance is measured. If an investment consistently falls short of its expected return, it may signal a need to re-evaluate the investment or the underlying assumptions.
• Capital Budgeting: Businesses utilize expected market return as a discount rate when evaluating potential projects or acquisitions. This helps them decide if a project's anticipated cash flows justify the initial investment, often within a larger financial modeling framework.
• Risk-Adjusted Returns: Expected market return is integral to calculating risk-adjusted returns, helping investors understand if the expected compensation for taking on risk is adequate.
• Economic Forecasting: Large financial institutions and government bodies produce economic forecasts that implicitly or explicitly influence expectations for market returns. These forecasts consider factors like interest rates, inflation, and economic indicators. For instance, the International Monetary Fund (IMF) regularly assesses global financial fragilities and market volatility, which can impact expected returns.²

Limitations and Criticisms

Despite its importance, expected market return is subject to significant limitations and criticisms:

• Forecasting Inaccuracy: Predicting future market movements is inherently challenging. Financial markets are complex adaptive systems influenced by countless variables, many of which are unpredictable. As a result, actual returns frequently deviate from expectations.
• Assumptions of Models: Models like CAPM rely on simplifying assumptions that may not hold true in the real world (e.g., efficient markets, rational investors). The accuracy of the expected market return derived from these models is dependent on the validity of these underlying assumptions.
• Data Dependency: Estimates of expected market return often rely on historical data, but past performance is not a reliable indicator of future results. Market regimes can shift, making historical trends less relevant.
• Behavioral Biases: Investor sentiment and behavioral biases can significantly influence market prices and returns, often leading to irrational exuberance or panic that deviates from rational expectations.
• External Shocks: Unforeseen geopolitical events, technological disruptions, or health crises can rapidly alter market dynamics and invalidate previous expectations. The difficulty of incorporating these "black swan" events into forecasts is a major limitation of financial forecasting.¹

Expected Market Return vs. Historical Market Return

The terms "expected market return" and "historical market return" are often confused but represent distinct concepts.

Expected Market Return is a forward-looking projection of what an investment is anticipated to yield over a future period. It is an estimate based on current economic conditions, analyst forecasts, and various financial models. It reflects the future compensation an investor expects for taking on a certain level of risk.

Historical Market Return, conversely, is a backward-looking measure. It represents the actual gains or losses realized by an investment or market over a specific period in the past. While historical data can inform the estimation of expected returns by revealing long-term trends and volatility, it does not guarantee future performance. Investors frequently analyze historical market return as a component of quantitative analysis to understand past performance.

The primary difference lies in their temporal orientation: expected return looks to the future, while historical return reflects the past.

FAQs

Q: Why can't I just use historical returns as my expected market return?

A: While historical returns provide valuable data on past performance, they are not a direct indicator of future results. Market conditions, economic cycles, and other factors constantly change, meaning what happened in the past may not accurately reflect what will happen in the future. Expected market return attempts to incorporate these forward-looking elements.

Q: Who calculates and publishes expected market returns?

A: Various entities, including investment banks, asset management firms, economic research institutions, and governmental bodies (like the Federal Reserve for economic projections), publish their estimates of expected market returns or key components that influence them, such as expected earnings or economic growth. These are often used as inputs for asset pricing models.

Q: Is a higher expected market return always better?

A: Not necessarily. A higher expected market return is often associated with a higher level of risk. Investors must weigh the potential for greater returns against their personal risk tolerance and financial objectives. It's about finding the right balance for your individual circumstances.

Q: How often should I update my expected market return assumptions?

A: Expected market return assumptions should be reviewed periodically, especially when significant changes occur in economic conditions, interest rates, or market sentiment. While daily adjustments are impractical, a quarterly or annual review, or after major market events, is prudent for sound investment analysis.

Q: Can expected market return be negative?

A: Yes, expected market return can be negative, especially during periods of economic contraction or heightened uncertainty. A negative expected return suggests that, based on current projections, investors anticipate losing money on an investment over the specified future period.