Final answer:
A stock with an expected return that exceeds its required return is considered undervalued, implying that its price may rise as the market adjusts. This is based on how expectations influence stock prices and on the relationship between risk and return, where higher risk equates to higher potential returns.
Step-by-step explanation:
If a stock's expected return exceeds its required return, this suggests that the stock is undervalued. The required return is essentially the return that investors demand for taking on the risk of owning the stock. When expectations about future performance lead to an expected return higher than what is required, the price of the stock is likely to increase as more investors buy in, seeing it as a good deal. This aligns with the economic principles that view stock prices as a reflection of future expectations. As analysts and investors constantly research and adjust their expectations, stock prices fluctuate accordingly. A sustained gap between expected and required returns would likely correct over time as the market recognizes the stock's actual value.
The relationship between risk and return is also crucial in this context. High-risk investments must offer high returns to attract investors who are compensated for taking on more uncertainty. Over time, stocks have shown to have higher average returns than bonds, with savings accounts offering the least variability but also the lowest returns. This reflects the higher level of risk associated with stocks and the consequent higher expected return.