How to Use Market Risk Premium for Expected Market 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.

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.

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.