What components are used in market return expectations according to WME?

• A. Returns are based on historical equity index performance alone.
• B. Expected returns equal the risk-free rate plus a universal equity premium.
• C. Expected return equals the risk-free rate plus a risk premium adjusted for horizon and tax considerations.
• D. Returns are entirely unpredictable and cannot be estimated.

Answer: (C)

WME builds market return expectations by starting with a baseline risk-free rate and adding a risk premium that reflects the extra return investors require for taking on equity risk. Crucially, that premium isn’t fixed; it’s adjusted for the investor’s time horizon and tax considerations. A longer horizon can change the amount of risk investors are willing to accept and the likelihood of different outcomes, while taxes affect the after-tax return the investor actually receives. So the expected return is the risk-free rate plus a horizon- and tax-adjusted risk premium.

Relying on historical equity performance alone ignores forward-looking adjustments and the impact of taxes and investment horizon. Thinking there is a universal, one-size-fits-all equity premium oversimplifies the matter, since premiums vary with time horizon and tax circumstances. And treating returns as completely unpredictable disregards the structured approach WME uses to estimate expected outcomes.