The expected return is the amount that an investor can anticipate from a profit or loss on a specific investment. You can use the expected return formula to estimate the profit or loss on a particular stock or fund.
Definition and Examples
When you invest, there is no way to know in advance whether you will make a profit. Many factors influence the performance of a particular investment. The expected return is a tool to estimate the potential rate of return on a specific asset.
When you find multiple different return probabilities, combine them to obtain the total expected return.
How to Calculate the Expected Return
To calculate the expected return for a specific investment, you should use historical data to compute the likelihood of certain events occurring.
For example, let’s assume you want to calculate the expected return for a specific stock. Based on the returns over the past 30 years, you know this stock has the following probabilities:
- 17% probability of a return of 3.5%
- 25% probability of a return of 5%
- 30% probability of a return of 6.5%
- 16% probability of a return of 8%
- 12% probability of a return of 9.5%
To calculate the expected return for this stock, multiply each probability by its corresponding return and add the results together.
This is how you can calculate the expected return, E(R), for this stock:
E(R) = 0.17(0.035) + 0.25(0.05) + 0.30(0.065) + 0.16(0.08) + 0.12(0.095)
When you multiply each potential return by its corresponding probability, you can simplify the calculation to:
E(R) = 0.00595 + 0.0125 + 0.0195 + 0.0128 + 0.0114
Add those numbers together and you get 0.06215. Multiply that by 100 to get the percentage that represents the expected return for the stock. In this example, the expected return for the stock is 6.22%.
In addition to calculating the expected return for a specific investment, you can also calculate it for your entire portfolio. To do this, you will need to find the weighted expected return for all the assets in your portfolio, E(Rp). This is the form of the formula:
E(Rp) = W1E(R1) + W2E(R2) + …
In this formula:
- W = weight of each asset, and they should all sum to 1
- E(R) = expected return for each individual asset
For example, let’s assume you have a portfolio composed of three different stocks. Stock A makes up 25% of your portfolio and has an expected return of 7%. Stock B makes up 40% of your portfolio and has an expected return of 5%. Stock C makes up 35% of your portfolio and has an expected return of 8.5%.
To calculate the expected return for your portfolio, use the following calculation:
E(Rp) = 0.25(0.07) + 0.40(0.05) + 0.35(0.085)
After multiplying and summing all returns, you will get 0.06725. Multiply it by 100. The result shows an expected return of 6.73%.
It is important to note that the expected return for a specific asset may vary depending on the holding period. The global investment firm BlackRock gathers data on the expected return for a variety of assets. According to its data, the average expected return on U.S. small-cap stocks held for five years is 6.2% annually. But for the same stocks held for 30 years, the average expected return is 7.4% annually.
Advantages and Disadvantages of Knowing the Expected Return
The expected return can be an effective tool for estimating potential gains and losses on a specific investment. Before engaging in that, it’s important to understand the advantages and disadvantages.
Advantages
- Helps investors estimate their portfolio’s return: The expected return can be a useful tool to help you understand how much return you can expect from your current investments based on historical performance.
- Can assist in guiding asset allocation for the investor: In addition to determining the potential return for a portfolio, you can use the expected return to help you make investment decisions. Return is a significant factor that investors consider when choosing their investments. Knowing the expected return for each asset may help you determine where to place your money.
Disadvantages
- Not
To ensure actual returns: It is very important for investors using the expected return formula to understand what it is. The expected return is based on historical returns, but past performance does not guarantee future results. The expected return on any particular asset or portfolio should not be the only thing you look at when making investment decisions. - Does not account for investment risk: The expected return for a specific investment does not take into account the level of risk that comes with it. In the case of high-risk investments, returns are often extreme in either direction – they can be very good or very bad. You cannot ascertain this by looking at the expected return. The difference in risk will not be evident when comparing two investments with different levels of risk.
Alternatives to Expected Return
The expected return is one of the tools you can use to evaluate your portfolio or a potential investment, but it is not the only tool available. There are other tools that can be used to fill some of the gaps left by the expected return formula.
Expected Return vs. Standard Deviation
Standard deviation is a measure of the level of risk of an investment based on how much the returns vary from the average. When a stock has a low standard deviation, its price remains relatively stable, and returns are usually close to the average. A high standard deviation indicates that the stock can be very volatile. This means that your returns could be much higher or much lower than the average.
The benefit of standard deviation is that, unlike the expected return, it takes into account the risks associated with each investment. While the expected return is based on the expected average return for a particular asset, the standard deviation measures the likelihood of actually seeing that return.
Expected Return vs. Required Rate of Return
The required rate of return refers to the minimum return you will accept for an investment worth pursuing. The required rate of return generally increases with the level of risk associated with the investment. For example, investors are usually happy to accept a lower return on bonds compared to stocks, as bonds typically carry less risk.
You can use the required rate of return and the expected return together. When you know the required rate of return for an investment, you can use the expected return to decide whether it is worth pursuing or not.
What Does This Mean for Individual Investors?
You can calculate the expected return for an individual investment or your entire portfolio. This information may help you understand the potential returns before adding an investment to your portfolio.
However, when it comes to using the expected return to guide your investment decisions, it is important to take what you find with caution. The expected return relies entirely on historical performance. There is no guarantee that future returns will be similar. It also does not account for the level of risk associated with each investment. The expected return for an asset should not be the only factor you consider when deciding whether to invest.
Additionally, as data from BlackRock has shown, the expected return for an investment can vary significantly over time. While the expected return may help long-term investors plan their portfolios, it does not apply well to day traders.
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Sources:
- The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
- BlackRock. “Capital Market Assumptions.”
Source: https://www.thebalancemoney.com/what-is-expected-return-5183780
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