Question

Why is it important to analyze the difference between Expected Returns and Required Returns?

What are the differences between Arithmetic and Geometric Returns?

Why are Geometric Returns used for Performance Analysis or Projections?

Why are returns annualized?

Answer 1

Expected rate of return refers to the expected return which an investors expect to collect when investing a stock. it is the amount of profit or loss an investor can anticipate receiving on an investment over time. While required rate of return is a minimum rate of return that investors wants to earn while investing in a project giving the project riskiness. it is a minimum rate of return which should be earned taking into consideration the risk associated with the investment.

Major point of difference between arithmetic average and geometric average is the use and situation. Arithemetic average is suitable in the situation where variables are not dependent on each other while geometric average is preferred to use in the situation where variables are dependent on each other. Geometric average consider compounding effect over the year while arithmetic average does not consider compounding effect, even it is calculated by adding all the variables values and divide them number of variables. Another point of difference between is arithmetic average is always greater than the geometric average.

Geometric Returns are used for Performance Analysis or Projections because geometric average consider the compounding effect while calculating the return over the period. Return on investment for a Investment portfolio dependends on returns earned in previous years so geometric average is the correct way to calculate return on the investment for a specific time period and it consider compounding effect and rate of increase and decrease through out the period of investment.

Returns are annualized because amount of gain or loss earned in a year, is independent of value of previous year due to compounding. Annualized returns help investor to compare the return of a year with the returns of previous years.