A:

In some cases, brokerage firms provide an expected market rate of return based on an investor's portfolio composition, risk tolerance and investing style. Depending on the factors accounted for in the calculation, individual estimates of the expected market return rate can vary widely.

For those who do not use a portfolio manager, 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, or DJIA, or the Nasdaq.

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 on a given investment.

The market risk premium represents the percentage of total returns attributable to the volatility of the stock market, and is calculated by taking 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 Treasury bills (T-bills). Though 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.

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 return rate for short-term T-bills is 5%, the market risk premium is 7% to 5%, or 2%. However, the returns on individuals stocks may be considerably higher or lower depending on their volatility relative to the market.

RELATED FAQS
1. ### How is the risk-free rate determined when calculating market risk premium?

Learn how the risk-free rate is used in the calculation of the market risk premium, and understand why T-bills provide the ... Read Answer >>
2. ### How do I calculate the equity risk premium in Excel?

Find out how to calculate the equity risk premium for an individual security using Microsoft Excel, including how to estimate ... Read Answer >>

4. ### The real rate of return is the amount of interest earned over and above the?

The real rate of return is the amount of interest earned over and above the: a. discount rate. b. tax rate. c. inflation ... Read Answer >>
5. ### What is the difference between yield and return?

Return is the financial gain or loss on an investment. Yield measures the income, such as interest and dividends, from an ... Read Answer >>
6. ### How is bond yield affected by monetary policy?

Learn about how bond yields are affected by monetary policy. Monetary policy determines the risk-free rate of return, which ... Read Answer >>
Related Articles
1. Investing

Market risk premium is equal to the expected return on an investment minus the risk-free rate. The risk-free rate is the minimum rate investors could expect to receive on an investment if it ...
2. Investing

### What Investors Should Know About Interest Rates

Understanding interest rates helps you answer the fundamental question of where to put your money. Learn about the relationship between rates and stocks.
3. Investing

### How Risk Free Is the Risk-Free Rate of Return?

This rate is rarely questioned—unless the economy falls into disarray.
4. Investing

### Calculating the Equity Risk Premium

See the model in action with real data and evaluate whether its assumptions are valid. Here is how to calculate the equity risk premium.

Measuring the success of your investment solely on the portfolio return may leave you blindsided to risk. Learn how to evaluate your investment return.
6. Investing

### Understanding The Sharpe Ratio

The Sharpe ratio describes how much excess return you are receiving for the extra volatility that you endure for holding a riskier asset.
7. Investing

### The Money Market: A Look Back

Learn how past inflationary periods can predict future real rates of return for cash investments.
8. Investing

### Why You Should Stick with Stocks over the Long Term

Over the long term, it pays to stick with stocks, despite the inevitable bouts of volatility that wrack stock markets from time to time.

### A Deeper Look At Alpha

The Jensen index helps investors compare realized returns to what should've been achieved.

### A Guide on the Risk-Adjusted Discount Rate

When a project or investment faces higher amounts of risk or uncertainty, it may be appropriate to utilize the risk-adjusted discount rate.
RELATED TERMS
1. ### Risk-Free Return

Risk-free return is the theoretical return attributed to an investment ...

A risk premium is the return in excess of the risk-free rate ...
3. ### Risk Discount

A risk discount refers to a situation where an investor is willing ...
4. ### Risk-Free Rate Of Return

The risk-free rate of return is the theoretical rate of return ...
5. ### Capital Asset Pricing Model - CAPM

Capital Asset Pricing Model (CAPM) is a model that describes ...

Equity risk premium refers to the excess return that investing ...
Hot Definitions
1. ### Yield Curve

A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
2. ### Portfolio

A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
3. ### Gross Profit

Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
4. ### Diversification

Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
5. ### Intrinsic Value

Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
6. ### Current Assets

Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...