How to find the Expected Return and Risk
How to calculate the expected return of an investment
The formula and procedures to determine the anticipated return on investment are as follows:
Return anticipated equals (return A times probability A) plus (return B times probability B).
Expected return on investment example
As an investor, you are considering three different investment options. You find the following performance results after looking at each investment option’s performance over the previous five years:
If all return scenarios have an equal chance of happening again, there is a 20% chance that each one will. You calculate the expected return of each investment as follows:
Investment A in this example has the highest expected return at 10 4%.
What is expected return?
As a result of the high volatility of the investment market, the expected return is just one of many potential returns. The expected return, however, is determined using a weighted average result because it considers the investment’s previous performance. Keep in mind that there is no assurance of future results because the expected return is based on historical data.
How to calculate the expected return of a portfolio
To determine the expected return of a portfolio of investments with various likely returns, follow these steps:
Expected return on portfolio example
The same as in the preceding example, you choose to set up a portfolio and invest in each of the three investments. You make the decision to invest 50% of your portfolio in Investment A, 30% in Investment B, and 20% in Investment C. You determine your entire portfolio’s expected return using the formula below:
The overall portfolio’s anticipated return in this example is 8 86%.
Advantages of calculating expected return
Identifying the anticipated return on an investment or portfolio has several benefits. Most significantly, it enables you to compare the likelihood of various investment outcomes based on historical data. You can examine how a specific investment performed in the past under specific market conditions to predict how it will perform in the future under those same conditions.
Disadvantages of calculating expected return
There are also a couple of limitations to expected return. The most notable is the volatility of the market. The expected return depends on speculating on various market conditions and the likelihood of each scenario because market conditions cannot be guaranteed. Market pressures can be categorized as either systematic risks that affect an entire investment type or unsystematic risks that are unique to a single company, nation, or industry.
The expected return on an investment may not match the actual return as a result of this. Calculations of expected return are also “backward-looking,” which means they base their conclusions on past performance data rather than current market conditions and other variables like regulatory changes or the state of the economy.
FAQ
What do you mean by expected return?
The primary benefit of calculating expected return is that it provides investors with a sense of whether they will make a profit or a loss. Investors can decide on a course of action based on their findings once they receive an estimated return.
How do I calculate my expected return?
The profit or loss an investor can anticipate realizing from an investment is known as the expected return. In order to calculate an expected return, potential outcomes are multiplied by the likelihood that they will occur, and the results are then added up. Expected returns cannot be guaranteed.
What is the purpose of an expected return?
A measure of probabilities known as “expected return” simply indicates the likelihood that an investment will result in a positive return and what that return is likely to be. The goal of calculating an investment’s expected return is to give a potential investor a sense of the potential profit vs. risk.
