An expected return is the income or loss generated from an investment that investors expect based on a rate of return assumed by them. It is a good tool for making sound and wise investment choices. However, there are some things investors must keep in mind before using Expected Return to dictate their investment choice. In this post, we will discuss Expected Return and the basic aspects associated with it. Once you are done reading this post, you will have a clearer idea of the subject matter. Let’s get started.
Expected Return: How to Calculate?
What is Expected Return?
The Expected Return is the profit or loss anticipated by an investor on an investment that has known or anticipated rates of return (RoR). Expected Return is calculated by multiplying potential outcomes by the chances of them occurring, and totaling the products in the end. For example, if an investment has a 60% chance of gaining 30% and a 60% chance of losing 10%, the expected return is 12% (60% x 30% + 60% x -10% = 12%).
How Does Expected Return Work?
The expected return is an extremely useful tool for determining if an investment is going to produce a positive or negative net outcome. The sum is calculated as the expected value (EV) of an investment given its potential returns in different scenarios, as illustrated by the following formula:
Expected Return = SUM (Returni x Probabilityi)
In the formula, the subscript “i” indicates each known return and its respective probability in the series
More often than not, the expected return is usually dependent on historical data and by virtue of that, the future numbers can’t really be guaranteed. In the example we discussed early on, for instance, the 12% expected return may never be realized in the future. The main reason behind that is the fact that all investment is always subject to systematic and unsystematic risks. Systematic risk covers the danger associated with a market sector or the entire market whereas unsystematic risk only covers the danger associated with specific companies or industries.
What are the limitations of Expected Return?
While Expected Return is a good tool for anticipating profit or loss, it should never be the only tool that decides the investment decisions made by you. Prior to making any buying decisions, investors should never forget to review the risk characteristics of investment opportunities. This is crucial for determining if the investments align with the investors’ portfolio goals.
Let’s take the example of the following hypothetical investments. Let’s list out their annual performances over the last five years.
- Investment A: 12%, 2%, 25%, -9%, and 10%
- Investment B: 7%, 6%, 9%, 12%, and 6%
As per the formula discussed earlier, both Investment A and Investment B will have expected returns of 8%. However, the risk analysis of both Investment A and Investment B shows a slightly different picture. Analysts generally utilize standard deviation to reveal the historical volatility in investments. As per the risk analysis, Investment A turns out to be almost five times as risky as Investment B. That is mainly because the standard deviation of Investment A is 12.6% while that of Investment B is 2.6%.
On top of expected returns, savvy investors should also consider the likelihood of a return for better risk assessment. Some great examples of that are certain lotteries which offer positive expected return, despite extremely low chances of those returns ever being realized.
Essentially, these are the pros and cons of expected returns:
- Gages the performance of an asset.
- Weighs different scenarios.
- Doesn’t take risk into account.
- Based largely on historic data.
Expected Return: Real World Example
The application of expected return isn’t solely limited to a single security or asset. It can also be expanded and used to analyze a portfolio containing many types of investments. In case the expected return of each investment is known, the overall expected return of the portfolio is a weighted average of the expected returns of its components.
Let’s use the real world example of a savvy technology sector investor. Let’s assume that the investor’s portfolio is made up of the following stocks:
- Alphabet Inc., (GOOG): $500,000 invested and an expected return of 15%
- Apple Inc. (AAPL): $200,000 invested and an expected return of 6%
- Amazon.com Inc. (AMZN): $300,000 invested and an expected return of 9%
The total portfolio size is $1 million. So the weights of Alphabet, Apple, and Amazon in the portfolio are 50%, 20%, and 30%, respectively.
Now, we can utilize the formula discussed earlier and calculate the expected return of the total portfolio using it:
- (50% x 15% = 7.5%) + (20% x 6% = 1.2%) + (30% x 9% = 2.7%)
- (7.5% + 1.2% + 2.7% = 11.4%)
Hence the expected return of the portfolio is 11.4%.
So that was a brief introduction to the world of Expected Return. Hopefully, you can use the information given in this post to use it to enhance your portfolio and reap better returns from your investments.