Expected Returns: An Investor's Guide to Harvesting Market Rewards

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Rational theories on expected return determination

• New academic views on expected return drivers are more complex—and more realistic—than the neoclassical CAPM-and-efficient-markets view.

• Expected return differentials across assets reflect rational risk premia as well as market inefficiencies and supply–demand effects.

• Instead of a single equity market factor, many rational risk factors as well as liquidity and skewness characteristics appear to influence expected asset returns.

• Risk premia are higher for assets or factors (e.g., equities, carry strategies) that fare poorly in bad times, whereas safe haven assets (e.g., government bonds) may even have negative risk premia over cash.

• Expected returns can vary over time due to rationally time-varying risk or risk aversion and due to investor irrationality and sentiment.

• The efficient markets hypothesis has been challenged by various anomalies and financial crises but its main implication—that beating the market is very difficult—remains valid for most investors.

This chapter reviews the revolution in academic thinking about expected returns. Twenty-five years ago the consensus assumptions included

• a world with a single risk factor—the asset’s sensitivity to the equity market (i.e., the CAPM beta);

• constant expected returns over time;

• investors care only about the means and variances of asset returns;

• frictionless markets; and

• efficient markets/rational investors.

The current view is more complex but also more realistic. ...