Expected Return

The expected return is the amount of money, which an investor thinks he or she may receive from an investment. To estimate this amount an investor should be aware of the historical rates of return for this investment. The formula is quite easy and includes two variables and two steps. The first one is potential outcomes, the second one is the chances of these outcomes to occur. The first step is to multiply these variables, the second is to total the results. However, investors always need to remember that no results can’t be predicted with unmistakable accuracy.

How does Expected Return work

It goes without saying that the expected return formula is the center calculation in numerous financial theories, such famous ones as the modern portfolio theory (also known as MPT), the Black-Scholes model, etc. The outcome of such a formula may be both positive and negative. In order to figure it out, there is a special formula. It’s given below:

here “i” stands for the every return of which an investor is aware and its respective probability in the row

For instance, if an investor has an investment, he or she evaluates that the chances to gain 10% equals 60%, while chances to lose 5% equals 40%. Thus, the expected returns would be 8%. 60% x 10% + 40% x -5% = 8%.

The expected return is deeply connected with the whole history of returns thus, it allows investors to make predictions according to historical data. Since there are only predictions, nobody can say for sure whether it’s going to become true or not. Nevertheless, there may exist decent expectations. In order to see the approximate expected returns you need to calculate the long-term weighted average of historical returns.

However, the 8% return has chances to never become true, since there are various collateral and certain risks. Moreover, these risks may be both systematic and unsystematic. Systematic risks refers to the sector or the whole market issues, while unsystematic risks are connected with the problems of a company.

In case of individual investments or portfolios the following formal formula of estimating the expected return is rather more appropriate:

Generally, the equation affirms that in case the risk-free rate of return exceeds it will depend on the investment's beta, or on the relative volatility.

The expected return is a great tool for statistical calculations in case someone wants to study a portfolio and make different conclusions about it. This measure makes predictions about the amount of money that returns, thus, it becomes an average of probable return distribution. The standard deviation may also be concluded in the list of such tools. This measure gauges deviations from the average return, thus, this measure may be regarded as something that predicts portfolio’s risks.

Advantages and disadvantages of Expected Return

The best way to invest is to analyze all risks or risk-return tradeoffs firstly, since relying on the mere expected return may turn negative. In case risks are too high, they exceed returns or these risks won’t bring the results that would satisfy an investor, it may be better to reconsider the investing strategy. Also, it's better to always consider whether investments that an investor makes are likely to bring return or not.

Thus, the expected return measure has advantages and disadvantages. 

Advantages. They include evaluation of the performance of an asset and different scenarios that are considered during the evaluation.

Disadvantages. Among all two are distinguished. The first disadvantage is that the expected return doesn’t consider risks and the second one is that the expected return is mostly based on historical facts that may be proved by expected results as much as may be not.