Find out why you should worry about the difference between objective and expected returns on investments – 01/25/2024 – From Grão to Grão

I vividly remember my school days when the teacher introduced an intriguing concept into our English classes: phrasal verbs. The idea that putting simple words together could create complex and unique meanings was fascinating. Similarly, in the world of finance, a deep understanding is necessary to differentiate terms that appear identical, but in reality, have different meanings.

Today, I will clarify two concepts that are often used interchangeably in the financial market, but which are fundamentally different: “objective return” or “target return” and “expected return”.

Understanding these terms is crucial for any investor who wants to successfully navigate the world of investing.

Let’s start with the “expected return”.

This term, often misinterpreted as a guarantee, is actually a projection based on scenarios and probabilities.

For example, a fund manager might estimate an expected return of 15% per year. This number could be derived from a scenario with a 25% chance of achieving 30% per year, a 25% chance of achieving no return, and a 50% chance of achieving 15% per year.

When we multiply each scenario by its respective return and add them together, we obtain the expected return.

But what happens when a manager declares an “objective return” of 30% per year?

This number often represents the most optimistic scenario, which, in our example, would occur with only a 20% probability.

It is crucial that investors question and understand the probabilities associated with each scenario to realistically assess the possible results they can obtain from the investment.

For example, would you accept investing in something that the manager says has a target return of 30% per year, but has a 20% chance of yielding nothing?

Confusion intensifies when experts confuse terms or use them interchangeably.

A worrying situation occurs when an expert, instead of referring to the objective return, declares an “expected return” of 30% per year. This can lead to significant misunderstandings, as expected return should not be confused with desired return.

This problem is not limited to variable income investments.

I remember influencers discussing expected returns of 30% per year on public bonds traded on Tesouro Direto, which offer rates of IPCA + 5.5% per year. A 30% return may be an objective in years of sharply falling interest rates, but it is essential to understand that this represents only a scenario, not an expectation of the bond’s return over the years.

Finally, whenever you hear about return, question the possible scenarios and their respective probabilities. This way, you will be able to understand and be prepared for adverse scenarios, minimizing frustrations and making more informed investment decisions.

Michael Viriato is an investment advisor and founding partner of Investor’s House.

Speak directly to me via email.

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