Complete Guide To Corporate Finance

Return, Risk And The Security Market Line - Expected And Unexpected Returns

As we described earlier, expected return is the average of a probability distribution of possible returns.

Although this is what you expect the return to be, there is no guarantee that it will be the actual return. However, shareholders' expectations are already factored into expected returns. Sometimes news confirms investor expectations and has no effect on stock price. Unexpected news can affect share price in a negative or positive way depending on whether it differs from expectations in a negative or positive way. Keep in mind that positive news that is not as good as investors expected can cause a stock's price to move down, while negative news that is not as bad as investors expected can cause a stock's price to move up.

Unexpected return is the portion of an investment gain or loss that is attributable to unforeseen events. If a pharmaceutical company's new drug was rejected by the FDA and stockholders thought it would be approved, the decline in the stock's price based on that news would be an unexpected return.

Total Return = Expected Return + Unexpected Return

Actual return is an investor's real gain or loss.

Actual return can be expressed in the following formula:

Actual Return = Expected Return (ex-ante) + Effect of Firm-Specific and Economy-Wide News

As opposed to expected return, actual return is what investors actually receive from their investments. The discrepancy between actual and expected return is due to systematic and unsystematic risk. (For more on this subject, read Is The Stock Market Really Worth Your Money? and 5 Signs Of Winning Investments.)

The Capital Asset Pricing Model (CAPM)
Pronounced as though it were spelled "cap-m," this model was originally developed in 1952 by Harry Markowitz and fine-tuned over a decade later by others, including William Sharpe. The capital asset pricing model (CAPM) describes the relationship between risk and expected return, and it serves as a model for the pricing of risky securities.

CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat our required return, the investment should not be undertaken.

The commonly used formula to describe the CAPM relationship is as follows:

Required (or expected) Return = RF Rate + (Market Return - RF Rate)*Beta

For example, let's say that the current risk free-rate is 5%, and the S&P 500 is expected to return to 12% next year. You are interested in determining the return that Joe's Oyster Bar Inc (JOB) will have next year. You have determined that the stock's beta value is 1.9. The overall stock market has a beta of 1.0, so JOB's beta of 1.9 tells us that it carries more risk than the overall market; this extra risk means that we should expect a higher potential return than the 12% of the S&P 500. We can calculate this as the following:

Required (or expected) Return =
5% + (12% - 5%)*1.9
Required (or expected) Return =
18.3%

What CAPM tells us is that Joe's Oyster Bar has a required rate of return of 18.3%. So, if you invest in JOB, you should be getting at least 18.3% return on your investment. If you don't think that JOB will produce those kinds of returns, then you should consider investing in a different company.

It is important to remember that high-beta shares usually give the highest returns. Over a long period of time, however, high beta shares are the worst performers during market declines (bear markets). While you might receive high returns from high beta shares, there is no guarantee that the CAPM return is realized. (Learn more about CAPM in The Capital Asset Pricing Model: An Overview, Taking Shots At CAPM, Reduce Your Risk With ICAPM and Catch On To The CCAPM.)

We'll explain systematic risk, unsystematic risk and beta in the next section.



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