Required Rate of Return

When an individual invests his hard-earned money in anything, he expects it to grow at a certain rate and not remain stagnant. This is exactly what a required rate of return does. It gives the investor an assurance of a minimum rate of return (expressed as a part of percent) on his investing capital. It is the most essential concept of evaluating your investments. Most of the investors and analysts use the RRR (required rate of return) to know the future cash flows from investments. RRR is also referred to as the "magic number" or "hurdle rate of return".

Required Rate of Return Formula

If an investor has his money in a savings account earning 5% annual interest, and now he wants higher returns, he considers investing in a risk-free treasury bond. The reasoning is that the investment must yield him more than 5% per year on the treasury bond, for him to consider taking his money out of the savings account and investing it in the bond. In this case, 5% would be the investor's minimum required rate of return.

Required Rate of Return = Risk-free Rate + Beta (Market Rate of Return - Risk-free Rate)

Required Rate of Return Calculator

The required rate of return calculator, helps the investor to measure his investment profitability. These calculators help you know the exact amount of money lost or gained on your investments, whether it is stock or an overall portfolio. Using a required rate of return calculator resource, makes calculations easy, provided you feed it with the risk free rate and market rate. It calculates the expected rate of return for you.

For example, if

Beta = 1.2
Market Rate of Return = 7%

Substituting the above figures in the formula, will give you the required rate of return.

Required rate of return = 5% + 1.2 (7% - 5%) = 7.4%

Required Rate of Return Calculation

Ross is an investment banker and looks after his own investments. He evaluates the market, and most of his investment options prove successful and earn him good returns. The rule is, higher the investment risk, greater the investment returns, and greater the potential investment loss as well. Joey and Ross are good friends. Joey is confused about his investment options and does not know which option can fetch him good returns. Therefore, he seeks help from Ross. Here is what Ross has to say about the investment options.

OPTION - 1

Risk-Free rate = 5%
Beta = 1.2
Market Rate of Return = 9%
Required rate of return = 5% + 1.2 (9% - 5%) = 9.8%

OPTION - 2

Risk-Free rate = 5%
Beta = 1.2
Market Rate of Return = 7%
Required rate of return = 5% + 1.2 (7% - 5%) = 7.4%

Ross advises Joey to go in for the second option. Even though the first option looks attractive and would fetch him good returns; higher the rate of return, higher is the fear of loss associated with it. Hence, Ross advises to less risky investment options to protect Joey's investment asset. Had Joey not calculated and analyzed the required rate of return for both the options, his investments would have been prone to more risk. Thus, Ross used his experience to guide Joey the humble way and to play it safe!