What is the Expected Return or Expected Portfolio Return?
Taking the probability distribution of the possible returns an investment can generate into account, investors can estimate the expected return on their investments. A variable with an unknown value will have different probabilities depending on its value. Calculate the expected return by multiplying the potential outcomes (returns) by their chances of occurrence and then summing them.
An investment’s return can be viewed as a randomly fluctuating variable within a given range. Based on historical data, the expected return may or may not be reliable for forecasting future returns. This does not guarantee a successful outcome. In simple terms, expected return measures how likely it is that an investment will generate a positive return as well as the likely size of that return.
An investment return calculation helps an investor evaluate the probability of profit and risk associated with their investment. Comparing this rate of return with that of risk-free returns provides the investor with a basis for comparison. Interest rates for three-month Treasury bills represent the risk-free rate of return.
What is the formula for calculating investment return?
Using the following steps, a formula for calculating expected returns for investors with different expected returns can be constructed:
- First, the value of an investment must be determined at the start of a period.
- Lastly, it is necessary to determine the value of the investment at the end of the period. Nevertheless, there can be multiple probable values attached to the asset, so the price or value of the asset must be weighed against the probability of it.
- In order to calculate the return at each probability, you should know the asset value before and after the period.
- Last but not least, we calculate the expected return of an investment with different probable returns as the sum of each probable return and its corresponding probability.
Expected return = r2 * p1 + r2 * rn + (rn * pn)
What is the formula for calculating expected returns?
In contrast, the following steps used to calculate an expected return formula for a portfolio:
- The first step in determining the return from each investment is to determine r, which is the return from each investment in the portfolio.
- The next step is to determine the weight of each investment, indicated as w.
- Final step: As shown below, the equation of expected return for the portfolio is derived by adding up the weighted average investment return and the corresponding investment return, thus, calculating the expected return equation.
Expected return = (w1 * r1) + (w2 * r2) + ………… + (wn * rn)
The Limitations of Expected Portfolio Return
The market is volatile and unpredictable, making it hard to accurately predict a security’s return. This may result in an inaccurate expectation of the overall portfolio’s return.
Making investment decisions based on returns alone can be dangerous because they don’t paint the complete picture. As an example, these decisions ignore volatility. Yearly investment returns can be the same whether the securities have high gains or losses. Expected returns are based on past performance. They do not take into account current market conditions, political and economic climates, legal and regulatory changes, etc.
Factors that influence risk tolerance
When evaluating a potential investment, the concept of expected return is an important part of the process. Individual investors may consider additional factors when creating an investment portfolio that matches their personal investment goals and risk tolerance, although analysts have come up with straightforward mathematical formulas for calculating expected returns.
Investors may consider conditions such as the current economic climate and investment climate. It is common for investors, even those who are normally risk-averse, to gravitate toward generally safe investments and those with low volatility during times of extreme uncertainty. So even if an investor’s calculations show an excellent return average, they might avoid stocks with high standard deviations from their average.
The stock’s previous performance also plays a role in calculating expected returns. Investors, however, who believe that a company is likely to significantly outperform its historical norms in the future, may choose to invest in a stock that doesn’t seem that promising on the basis of solely expected return calculations. Return on investment (ROI) is a financial metric that compares the value of profits a company generates through increased capital investment. This is a helpful financial metric to consider in addition to the expected return.
Despite not being a guaranteed predictor, the expected return formula has proven to be an excellent analytical tool. It also assists investors in forecasting probable investment returns and in assessing portfolio risk and diversification.
An expected return refers to the probable return for a portfolio held by an investor based on past performance. In addition, it only utilizes past returns, it is a limitation. The value of expected return not the only factor considered when deciding whether to invest in a portfolio. Variance and standard deviation are also important measures to consider in the portfolio.