The expected return represents the amount of profit or loss an investor anticipates earning on an investment over a specific period. It’s a crucial concept in finance, allowing investors to compare the viable profitability of various investment options.
Definition and Formula
The expected return is mathematically expressed as the weighted average of possible returns, with each return weighted by its probability of occurring:
Where:
- \(E(R)\) represents the expected return.
- \(p_i\) is the probability of each return.
- \(R_i\) is the return in each scenario.
How It Works
Calculating Expected Return
To calculate the expected return, follow these steps:
- Identify Probable Outcomes: Determine the possible returns on the investment and their respective probabilities.
- Multiply Returns by Probabilities: Multiply each possible return by its corresponding probability.
- Sum the Products: Add all these products to get the expected return.
Example Calculation
Suppose an investment has three possible outcomes:
- 20% probability of a 10% return,
- 50% probability of a 5% return,
- 30% probability of a -3% return.
The expected return would be:
Limitations of Expected Return
While the expected return is a useful metric, it has some limitations:
- Assumes Probability Distribution: It relies on accurate probability estimates, which can be challenging to ascertain.
- No Consideration of Variability: It does not account for the variability (risk) of returns, which can result in misleading conclusions.
- Ignores Extreme Outcomes: Extreme outcomes with low probabilities are often disregarded, even though they might have significant impacts.
Historical Context
The concept of expected return has its roots in early 20th-century portfolio theory, pioneered by economists like Harry Markowitz. It became fundamental in the Capital Asset Pricing Model (CAPM), which furthered its application in investment strategies.
Applicability in Different Scenarios
Expected return is widely used in:
- Stock Market Investments: To compare potential stocks.
- Project Feasibility Studies: To evaluate the profitability of new ventures.
- Risk Management: To assess the risk-return profile of portfolios.
Related Terms
- Variance: A measure of the dispersion of returns around the expected return.
- Standard Deviation: The square root of variance, indicating return variability.
- Risk-Adjusted Return: The returns of an investment adjusted for its risk.
Frequently Asked Questions (FAQs)
How does expected return differ from actual return?
- The expected return is a forecast based on probabilities, while the actual return is the realized profit or loss.
Can expected return be negative?
- Yes, if the probabilities indicate higher losses than gains, the expected return can be negative.
Is a higher expected return always better?
- Not necessarily. A higher expected return often comes with higher risk, making it crucial to consider your risk tolerance.
References
- Markowitz, H. (1952). “Portfolio selection.” The Journal of Finance.
- Sharpe, W.F. (1964). “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.” The Journal of Finance.
Summary
The expected return is a foundational concept in finance, helping investors estimate the profitability of their investments based on probable outcomes. While it is invaluable, it comes with limitations, particularly regarding risk and probability estimates. Understanding its mechanics and applications enables more informed investment decisions.
