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I am learning the basics of portfolio management. I am confused about different ways to calculate rate of returns mentioned in the text investment and portfolio analysis.

There are three methods to calculate rate of return

  1. mean of last n years returns

  2. Through CAPM and Asset pricing theory

  3. Based on stock valuation and forecasting of earnings

So which one we should use and when, especially while trying to find optimal portfolio weights

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Each of these can be used, but each has serious drawbacks.

No. 1 is inaccurate unless you use $N>>10$ years of data. But decades of data may not be available or may no longer be relevant to today's economy.

No. 2 is good except that the CAPM has been rejected by empirical tests. More advanced models from Asset Pricing Theory may be helpful (FF3, FF5, HXZ [Hou, Xue, Zhang]) but are controversial.

No. 3 requires forecasts of earnings for 1 or more years and long term growth rates (past the forecast horizon), which are difficult to make with suitable accuracy.

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  • $\begingroup$ Thanks Alex, Which one of them is most commonly used in practice? $\endgroup$ – ashwinids Apr 11 '16 at 17:46
  • $\begingroup$ It depends on your goals and you must choose your limitations. No. 1 is probably used more often than it should be because it is so easy to get for stocks. $\endgroup$ – RndmSymbl Apr 30 '16 at 9:49

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