Expected Return
Expected Return is a crucial concept in finance and investment analysis. It refers to the anticipated value or profit that an investor can expect from an investment over a specific period. Expected return is typically determined through historical data and statistical measures, offering a probabilistic expectation of future returns. This value is calculated using various models and methods, often employed in portfolio management and risk assessment to compare and optimize different investment options.
Formula
The general formula for expected return is: \[ E(R) = \sum (P_i \times R_i) \] Where:
- \( E(R) \) is the expected return,
- \( P_i \) is the probability of each return,
- \( R_i \) is the return associated with probability \( P_i \).
Examples
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Simple Probability-Based Portfolio: Suppose you have two potential returns from an investment, with probabilities assigned to each. If return \( R_1 \) is 10% with a probability \( P_1 \) of 0.5, and return \( R_2 \) is -5% with a probability \( P_2 \) of 0.5, the expected return \( E(R) \) would be: \[ E(R) = (0.5 \times 0.10) + (0.5 \times -0.05) = 0.025\text{ or } 2.5% \]
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Expected Return on a Stock: Assume a stock might have returns of 12%, 5%, and -3% with probabilities of 0.4, 0.4, and 0.2 respectively. The expected return \( E(R) \) would be: \[ E(R) = (0.4 \times 0.12) + (0.4 \times 0.05) + (0.2 \times -0.03) = 0.061\text{ or } 6.1% \]
Frequently Asked Questions (FAQs)
Q: How is expected return different from actual return? A: Expected return is a forecast based on probabilities and historical data, indicating what an investor anticipates earning. Actual return is the return that an investor actually earns, which may differ due to market volatility and other factors.
Q: Can expected return guarantee future performance? A: No, expected return provides an estimate but cannot guarantee future performance because it doesn’t account for unexpected market fluctuations.
Q: How is expected return used in portfolio management? A: Expected return aids in optimizing the portfolio by helping investors choose a mix of assets that maximize potential returns while managing risk.
Q: What are the limitations of expected return calculations? A: The primary limitations include reliance on historical data that may not predict future performance and assumptions of fixed probabilities which may not hold in a dynamic market.
Related Terms
- Mean Return: The arithmetic average of returns over a specified period. It’s a simple calculation to estimate central tendency.
- Standard Deviation: Measures the dispersion of returns around the mean, indicating the investment’s volatility.
- Risk-Free Rate: The return on an investment considered free of risk, often depicted by government treasury bills.
- Sharpe Ratio: Used to assess the return of an investment relative to its risk, calculated as the difference between the return of the investment and the risk-free rate, divided by the standard deviation.
Online References
Suggested Books for Further Studies
- “Investments” by Zvi Bodie, Alex Kane, and Alan J. Marcus: A comprehensive guide covering fundamental concepts in investment analysis.
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen: A must-read for understanding corporate finance principles, including expected return.
- “Quantitative Investment Analysis” by Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, David E. Runkle: An in-depth resource on quantitative investment techniques.
Fundamentals of Expected Return: Finance Basics Quiz
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