Also known the magic number, hurdle rate, or RRR, a required rate of return is the amount of earnings or return that an investor must realize in order to invest his or her resources into a given security, joint venture, or other type of money making opportunity. Usually expressed in terms of a percentage, the expected return is often calculated on an annual basis, although some investors may use quarterly or even monthly percentage to evaluate the profitability of the activity. The responsibility for convincing an investor that a given opportunity will yield the required rate of return normally rests with the issuer of the security or business opportunity.
There is no exact formula for determining what all investors would consider to be a minimum or required rate of return. In fact, the process can be highly subjective. Factors such as the amount of the investment, the ability of the investor to hold the investment long enough to earn the return, and the personal financial goals of the investor are often part of the process of settling on what is considered a minimum requirement for return. This means that if the projected rate of return is 5%, one investor may feel this is a reasonable rate of return, while another investor would consider earnings of that percentage to not be sufficient.
When evaluating any investment, it is important to look at whether or not the generated return will in fact be acceptable. Often, this involves comparing the projected or expected return with other investment options. For example, an investor may note that two stock options that are currently selling at the same market price offer similar rates of return, with the anticipated return on one being 10% and the other 9%. Assuming that the degree of risk involved is the same with both options, the investor is more likely to go with the stock that is projected to produce a 10% return.
While this calculation of the expected return is very important, investors also consider other factors when determining the required rate of return. The level of risk is one example. If the stock that is projected to earn a 10% annual return is also considered to be a more volatile option, the conservative investor may choose to go with the other stock that offers a slightly lower percentage of return, but is also considerably less volatile. The general investment strategy of the individual investor will always affect what he or she perceives as a required rate of return.
