What is the Difference Between Expected Return and Required Return?

The expected return and required return are both important concepts in investment decision-making, but they serve different purposes and have distinct meanings.

Expected Return is the expected holding-period return for a stock in the future, based on expected dividend yield and the expected price appreciation return. It represents the return that an investor thinks they can generate if the investment is made. The expected return is a forecast or an anticipated gain on a financial investment.

Required Return is the minimum level of expected return that an investor requires over a specified period of time, given the asset's riskiness. It represents the minimum return that must be received for an investment to be considered worthwhile. The required return reflects the compensation that the investor receives for the risk borne.

The main differences between expected return and required return are:

1. Purpose: Expected return is a forecast or anticipated gain on an investment, while required return is the minimum level of return that an investor needs to justify the risk taken.
2. Basis: Expected return is based on expected dividend yield and price appreciation, while required return is based on the asset's riskiness and the investor's risk tolerance.
3. Comparison: If the security is valued correctly, the expected return will be equal to the required return. However, if the required return is higher than the expected rate, the investment security is considered to be overvalued.

In summary, the expected return represents the anticipated gain from an investment, while the required return represents the minimum level of return that an investor needs to justify the risk taken. These concepts help investors make informed decisions about their investments and evaluate the attractiveness of various opportunities.

Comparative Table: Expected Return vs Required Return

The difference between expected return and required return can be understood through the following table:

In summary, the expected return is the anticipated profit or loss on an investment based on probable outcomes, while the required return is the minimum return an investor needs to compensate for the risk associated with an investment. These two concepts are important for investors to make informed decisions about their investments.