How to Use Market Risk Premium for Expected Market Return

Important factors that impact your investment's rate of return

In some cases, brokerage firms will provide investors with an expected market rate of return based on an investor's portfolio composition, risk tolerance, and investing style. While in the process of building a new portfolio or rebalancing an existing portfolio, investors commonly review various expected rates of return scenarios before making an investment decision.

Depending on the factors accounted for in the calculation, individual estimates of the expected market return rate can vary widely. Here we review what investors should know about how the market risk premium can impact their expected market return.

Key Takeaways

  • An expected return is the return an investor expects to make on an investment based on that investment's historical or probable rate of return under varying scenarios.
  • Investors can use the historic return data of an index—such as the S&P 500, the Dow Jones Industrial Average (DJIA), or the Nasdaq—to calculate the expected market return rate.
  • Once an investor knows the expected market return rate, they can calculate the market risk premium, which represents the percentage of total returns attributable to the volatility of the stock market. 
  • By understanding the market risk premium, investors can estimate the reasonable expected rate of return of an investment given the risks of the investment and cost of capital.

Market Indexes and Expected Rates of Return

The expected return is the amount of money an investor expects to make on an investment given the investment's historical return or probable rates of return under varying scenarios. For those investors who do not use a portfolio manager to obtain this historical data, the annual return rates of the major indexes provide a reasonable estimate of future market performance.

For most calculations, the expected market return rate is based on the historic return rate of an index such as the S&P 500, the Dow Jones Industrial Average (DJIA), or the Nasdaq. To determine the expected return, an investor calculates an average of the index's historical return percentages and uses that average as the expected return for the next investment period.

Because the expected market return figure is merely a long-term weighted average of historical returns and is therefore not guaranteed, it's dangerous for investors to make investment decisions based on expected returns alone.

Market Risk Premium

The expected market return is an important concept in risk management because it is used to determine the market risk premium. The market risk premium, in turn, is part of the capital asset pricing model (CAPM) formula. This formula is used by investors, brokers, and financial managers to estimate the reasonable expected rate of return of an investment given the risks of the investment and cost of capital.

The market risk premium represents the percentage of total returns attributable to the volatility of the stock market. To calculate the market risk premium, you'll need to determine the difference between the expected market return and the risk-free rate.

The risk-free rate is the current rate of return on government-issued U.S. Treasury bills (T-bills). Although no investment is truly risk-free, government bonds and bills are considered almost fail-proof since they are backed by the U.S. government, which is unlikely to default on financial obligations.

Example of Market Risk Premium

For example, if the S&P 500 generated a 7% return rate last year, this rate can be used as the expected rate of return for any investments made in companies represented in that index. If the current rate of return for short-term T-bills is 5%, the market risk premium is 7% minus 5% or 2%. However, the returns on individual stocks may be considerably higher or lower depending on their volatility relative to the market.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. TreasuryDirect. "Treasury Securities & Programs."

Take the Next Step to Invest
×
The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.
Service
Name
Description