Expected Return - Explained
What is an Expected Return?
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Table of ContentsWhat is an Expected Return?How Does an Expected Return Work?Expected Return of a PortfolioLimitations of the Expected Return
What is an Expected Return?
The expected return of an investment refers to the return (either profit or loss) that an investor expects on an investment which is determined by the anticipated rates of returns. Investors can determine the expected rate of return of investment by multiplying the likely outcomes of the investment by the probability of the outcomes occurring. In the case of an investment portfolio, the expected return is determined by matching the weights of the investments with the anticipated returns.
How Does an Expected Return Work?
The expected return is an important metric that determines whether an investment will be profitable or otherwise. The average net outcome of an investment is also determined, which can either be positive or negative. It is important that investors assess the expected returns of investment, as well as the probability of return which will give an insight into the underlying risks of the investment. To calculate the expected rate of return of an investment, the following formula is applicable;
Expected Return = SUM (Returni* Probabilityi)
In the above formula, (i) means the known return and probability. In the case of an investment portfolio, the expected return is calculated as; R1 P1 + R2 P2 + Rn Pn (n here means scenario number).
Expected Return of a Portfolio
The expected return of investment is realized based on the potential returns of the investment. Typically, an expected return is determined using the weighted average of historical data or historical returns of previous investments. This shows that the expected return calculated for investment may not be attainable given the scenarios that unfold during the period of the investment. The expected return is not just calculated for single investments, it is also applicable for investment portfolios. In this case, the expected return is the anticipated rate of returns of the investments in the portfolio.
Limitations of the Expected Return
The major drawbacks of the expected rate of return include the following; It is not advisable to make investment decisions by just relying on the expected returns alone. This is because the expected return is not guaranteed since it is just based on historical data. The expected return of an investment is not a sufficient metric to determine whether an investment will yield profits or incur losses.