How to Calculate Portfolio Expected Return

Calculating a portfolio’s expected return is a fundamental practice for investors aiming to understand the potential performance of their combined assets. This metric provides a forward-looking estimation of the returns an investment portfolio might generate over a specific period. It helps investors set realistic expectations for growth, guiding them in making informed decisions about asset allocation and assessing how potential returns align with their financial objectives. While it offers a valuable projection, it is important to remember that expected return is an estimation based on various assumptions and is not a guaranteed outcome.

Gathering Essential Inputs

Before calculating a portfolio’s expected return, two crucial pieces of information are necessary: the expected return of each individual asset within the portfolio and the weight or proportion of each asset in the portfolio. These inputs form the foundation for an accurate calculation.

Estimating the expected return for single assets like stocks, bonds, or mutual funds involves various approaches. Historical average returns are a common method, though past performance does not guarantee future results. Analyst forecasts also provide professional predictions.

For stocks, models like the Dividend Discount Model (DDM) estimate returns by discounting future dividends. For bonds, Yield to Maturity (YTM) is often used, representing the total return if held to maturity. The Capital Asset Pricing Model (CAPM) also derives expected returns for equity, considering the risk-free rate, asset beta, and market risk premium.

Determining the portfolio weight for each asset is a straightforward process. The weight is calculated by dividing the market value of a specific asset by the total market value of the entire portfolio. For instance, if a portfolio has a total value of $100,000, and one asset is valued at $20,000, its weight in the portfolio would be 20% ($20,000 / $100,000). This calculation ensures that each asset’s contribution to the overall portfolio return is accurately reflected based on its proportion of the total investment.

The Portfolio Expected Return Formula

The core mathematical formula for calculating a portfolio’s expected return is a weighted average of the expected returns of its individual assets. This formula consolidates the prepared inputs into a single, comprehensive figure.

The formula is expressed as: Portfolio Expected Return = Σ (Weight of Asset_i Expected Return of Asset_i). Here, “Σ” signifies summation, indicating that the products for all assets in the portfolio are added together. “Weight of Asset_i” refers to the proportion that asset ‘i’ represents within the total portfolio, while “Expected Return of Asset_i” is the estimated return for that specific asset ‘i’.

The formula’s logic stems from its weighted average nature. Each asset contributes to the total portfolio return in proportion to its allocation. Assets with larger weights have a greater influence on the overall expected return. This formula projects a portfolio’s potential performance, showing how individual asset expectations combine.

Step-by-Step Calculation Example

To illustrate the application of the portfolio expected return formula, consider a hypothetical portfolio comprising three distinct assets: a stock, a bond fund, and a real estate investment trust (REIT). Assume these assets have already been assigned their individual expected returns and their respective portfolio weights determined.

For this example, let’s designate the following: Stock A has an expected return of 10% and a portfolio weight of 50%. Bond Fund B has an expected return of 4% and a portfolio weight of 30%. Real Estate Investment Trust C has an expected return of 8% and a portfolio weight of 20%. The sum of the weights (50% + 30% + 20%) equals 100%, representing the entire portfolio.

The calculation proceeds by multiplying each asset’s weight by its expected return. For Stock A, the weighted return is 0.50 (weight) 0.10 (expected return) = 0.05, or 5%. For Bond Fund B, the weighted return is 0.30 (weight) 0.04 (expected return) = 0.012, or 1.2%. For Real Estate Investment Trust C, the weighted return is 0.20 (weight) 0.08 (expected return) = 0.016, or 1.6%.

Finally, sum the results from each asset to arrive at the total portfolio expected return. Adding 5% (Stock A) + 1.2% (Bond Fund B) + 1.6% (REIT C) yields a portfolio expected return of 7.8%. This means the entire portfolio is anticipated to generate a 7.8% return over the specified period.