How to Find and Calculate Expected Return

Expected return is a forward-looking, probabilistic assessment of an investment’s average return over a specific period. It provides investors with a metric to evaluate potential investments and make informed decisions about where to allocate capital. This estimate considers various possible outcomes and their likelihoods, offering a structured way to anticipate future performance. Understanding how to calculate and apply expected return is important for any investor seeking to build a goal-oriented portfolio.

Understanding Expected Return

Expected return represents a weighted average of potential returns, where the likelihood of each return occurring serves as its weight. It is a projection that looks to the future, differing from historical returns which reflect past performance. While historical data can inform these projections, expected return focuses on what an investment is anticipated to yield going forward. This forward-looking perspective helps investors compare different investment opportunities on a consistent basis. It also aids in assessing potential profit against inherent risks.

Calculating Expected Return for a Single Investment

The expected return for a single investment is determined by summing the products of each possible outcome’s return and its corresponding probability. This calculation considers various scenarios, such as economic boom, normal growth, or recession, each with its own estimated return and likelihood of occurrence. The formula for expected return is the sum of (Return in Outcome Probability of Outcome). This method assesses potential gains or losses under different market conditions.

Consider an investment with three possible scenarios: a 20% chance of a 15% return, a 50% chance of a 10% return, and a 30% chance of a 5% loss. For instance, (0.20 0.15) + (0.50 0.10) + (0.30 -0.05). This calculation yields an expected return of 0.03 + 0.05 – 0.015, which equals 0.065 or 6.5%. This figure represents the average return anticipated over the long term for this specific investment.

Calculating Expected Return for a Portfolio

Calculating the expected return for a portfolio involves a similar weighted average approach, but it uses the expected returns of each asset within the portfolio. The portfolio’s expected return is the sum of each asset’s expected return multiplied by its weight in the portfolio. An asset’s weight signifies the proportion of the total portfolio value invested in that specific asset. This method provides a consolidated view of an entire investment collection’s anticipated performance.

For example, consider a portfolio with three assets: Asset A (8% expected return, 50% of portfolio), Asset B (12% expected return, 30% of portfolio), and Asset C (6% expected return, 20% of portfolio). The portfolio’s expected return is calculated as (0.50 0.08) + (0.30 0.12) + (0.20 0.06), which equals 0.04 + 0.036 + 0.012. This results in a portfolio expected return of 0.088, or 8.8%.

Estimating Inputs for Expected Return Calculations

Obtaining the necessary inputs for expected return calculations requires estimation of probabilities and potential returns. One common approach involves analyzing historical data, as past performance can offer insights into future expectations. Historical returns can provide a foundation for determining the probability of various outcomes or estimating average returns over time. For instance, the long-term average annual return of broad market indices like the S&P 500 can serve as a proxy for market return estimates.

Economic forecasts and prevailing market conditions also play a role in estimating inputs. Macroeconomic indicators such as GDP growth, inflation rates, and interest rates can help assign probabilities to different scenarios or adjust return expectations. For example, a forecast predicting economic expansion might lead to higher expected returns for certain assets. Financial analysts’ projections for company earnings or market performance provide another source of information. These consensus estimates offer a view of future performance.

A baseline for estimating expected returns can be established using the risk-free rate, typically represented by the yield on short-term U.S. Treasury securities. An equity risk premium is then added to this rate, which is the additional return investors expect for taking on the higher risk of investing in the stock market compared to a risk-free asset. This premium compensates investors for the inherent volatility and uncertainty of equity investments. These various inputs, though estimates involving judgment, are important for expected return formulas.

Applying Expected Return in Investment Analysis

Once calculated, expected return serves as a tool in investment analysis, guiding decision-making. It allows investors to compare different investment opportunities on a standardized basis, facilitating a clear assessment of their potential profitability. This comparative analysis is important when choosing between various assets or investment strategies. Investors can then identify which opportunities align best with their financial objectives.

Expected return is also considered alongside risk to evaluate whether the potential return adequately compensates for the level of risk undertaken. Investments with higher expected returns are associated with higher levels of risk, reflecting the risk-return tradeoff in finance. A higher expected return might be necessary to justify the increased risk exposure of certain investments. This consideration helps in making risk-adjusted investment decisions.

Expected return contributes to portfolio optimization, helping investors construct a portfolio that aligns with their personal goals and risk tolerance. By analyzing the expected returns of individual assets, investors can optimize their asset allocation to maximize potential returns for a given level of risk. This strategic application of expected return helps build a well-structured and diversified investment portfolio.