Why do people invest? Do people invest for the sake of investment? The main reason why people invest should be to earn money from the investment! When considering investing in something – whether it’s real estate or paper assets like stocks and bonds-is fair to ask: What is in it for me? We naturally would want an idea of much money we will make from the investment before actually investing! In simplest terms, the amount of money or the profit made from an investment is called the return on that investment. There are many terms associated with the return of an investment that can be confusing even to seasoned investors. In this article, we are going to explain what is meant by the expected return and show examples of portfolio expected return calculator.
What Is Rate of Return (RoR)?
Before we discuss expected return, let us define return and rate of return (RoR) first. Return is the profit made from an investment. It includes any changes in the value of the investment and/or cash flows (or securities or other investments) which an investor receives from that investment. These receipts include interest payments, coupons, cash dividends, stock dividends or the payoff from a derivative or structured product. It may be measured either in absolute terms (e.g., dollars) or as a percentage of the amount invested. A loss instead of a profit is described as a negative return, assuming the amount invested was more significant than zero.
As we already defined in the previous article, Expected Rate of Return Calculator, rate of return (RoR) results from the conversion of returns overtime periods of different lengths into a return over a period of time of a standard length. Typically, the period in a year, in which case the rate of return is also called the annualized return and the conversion process called annualization. The resulting value is called the internal rate of return (IRR). The rate of return can be further expressed as the expected rate of return (ERR) or simple expected return, which is the profit or loss that an investor anticipates on an investment that has known historical rates of return (ROR).
What Is Expected Return?
The Corporate Finance Institute defines expected return as the expected value of the probability distribution of possible returns it can provide to investors. The return on the investment is an unknown variable that has different values associated with different probabilities. The expected return is calculated by multiplying potential outcomes (returns) by the chances of each outcome occurring and then calculating the sum of those results. In the formula, the expected return is as follows:
Over short periods, the return on investment can be considered a random variable that can take any values within a given range. The expected return, on the other hand, is based on historical data, which may or may not provide a reliable forecast of returns in the future. Therefore, the outcome is not guaranteed. The expected return is simply a measure of probabilities intended to show the likelihood that a given investment will generate a positive return and what the likely return will be. The purpose of calculating the expected return on investment is to provide an investor with an idea of probable profit vs risk.
Calculating Expected Return
To illustrate expected return, let us consider calculating the expected return both of a single investment and a portfolio of investments.
Expected Return Of A Single Investment
Consider investment A with a 30% probability of giving a 15% return on investment, a 40% probability of generating a 10% return, and a 30% probability of resulting in a 5% loss. Note that the total probability is always 100%. Thus, based on the above formula, the expected return is:
(0.30*0.15) + (0.40*0.10) + (0.30*-0.05) = 0.045 + 0.040 – 0.015 = 0.070 or 7%
This is the probable long-term average return of investment A.
In this example, we are calculating a discrete probability distribution for potential returns. The probabilities of each potential return outcome are derived from studying historical data on previous returns of the investment asset being evaluated. The probabilities stated, in this case, might be derived from studying the performance of the asset over the previous 10 years. For example, assume that it generated a 15% return on investment during two of those 10 years, a 10% return for five of the 10 years, and suffered a 5% loss for three of the 10 years.
Expected Return Of A Portfolio
Now let us consider calculating the expected return of a portfolio. The expected return for an investment portfolio is the weighted average of the expected return of each of its components. Components are weighted by the percentage of the portfolio’s total value. Looking at the weighted average of portfolio assets can also help investors assess the diversification of investment portfolios.
Let’s look at this example from Investopedia: a portfolio has three investments with weights of 35% in asset A, 25% in asset B, and 40% in asset C. The expected return of asset A is 6%, the expected return of asset B is 7%, and the expected return of asset C is 10%.
Portfolio Expected Return Calculator
Since we already know how the expected return is calculated, let us look at available portfolio expected return calculators online. There are several available online calculators, such as those provided by organizations providing training, education, and certification for financial analysts like Educba. There are also free online calculators for financial calculations and metrics, such as the one from Calculate Online.
It is important to note that knowing the expected return of an investment is not the sole basis for making an investment decision. As will be discussed below, the expected return has limitations. Therefore, it should be used in conjunction with other metrics and consideration of investment risk and investor risk appetite.
Limitations of Expected Return
The expected return is closer to an educated guess than a firm prediction. The formula does not consider the volatility and unpredictability of the market. As a result, it could cause inaccuracy in the resultant expected return of the overall portfolio. Therefore, it is all the more important to get the assumptions right. Whether you’re calculating the expected return of an individual investment or an entire portfolio, the formula depends on getting your assumptions right.
For a portfolio, you will calculate the expected return based on the expected rates of return of each individual asset. But expected rate of return is an inherently uncertain figure. As an investor, you calculate it by assuming that the asset’s growth and yield in the past will continue unrelenting into the future. For example, if your stock returned dividends in the past year, it would continue to pay those dividends in future years. If it grew 10 per cent in the past year, it would grow by at least another 10 per cent this year.
These are not completely speculative assumptions, but neither are they necessarily reliable. While past performance can indicate future results, there are no guarantees. Expected returns, therefore, do not paint a complete picture, so making investment decisions based on them alone can be dangerous. As already mentioned, volatility is not taken into account. Securities that range from high gains to losses from year to year can have the same expected returns as steady ones that stay in a lower range. And as expected returns are backwards-looking, they do not factor in current market conditions, political and economic climate, legal and regulatory changes, and other elements.
Expected Return Versus Required Rate Of Return
This financial metric is often mentioned alongside expected return. The required rate of return (RROR) is the amount of money, or the proportion of money received back from money invested that a project needs to generate for it to be worth the investment. In other words, it answers the question of: “How much return should this investment earn for it to be worth investing in?” The expected return is the return based on past performance, while the required rate of return is return an investor requires before investing. This is important to investors because it tells the relationship between the risk of an investment and the potential profitability or return from it.
Expected Return Versus Standard Deviation
Standard deviation measures an investment’s risk level based on how far the return tends to deviate from its average. A stock with a low standard deviation means its price stays relatively stable, and returns stay close to the average. Conversely, a stock with a high standard deviation indicates volatility. This means returns have the potential to be significantly more or less than the average.
Standard deviation, unlike expected return, considers the risk associated with each investment. The expected return is based on the mean average return for a particular asset, while standard deviation measures the likelihood of actually seeing that return.
Analyzing Investment Risk
In addition to calculating expected return, investors also need to consider the risk characteristics of investment assets. This helps determine whether the portfolio’s components are properly aligned with the investor’s risk tolerance and investment goals.
Let us look at this example from the Corporate Finance Institute of two portfolio components showing the following returns, respectively, over the past five years:
Portfolio Component A: 12%, 2%, 25%, -9%, 10%
Portfolio Component B: 7%, 6%, 9%, 12%, 6%
Calculating the expected return for both portfolio components yields the same figure: an expected return of 8%.
When each component is examined for risk, based on year-to-year deviations from the average expected returns, you find that Portfolio Component A carries five times more risk than Portfolio Component B (A has a standard deviation of 12.6%, while B’s standard deviation is only 2.6%). Standard deviation represents the level of variance that occurs from the average return.
Risk Tolerance And Other Factors
When putting together an investment portfolio, investors must consider their risk tolerance, in addition to looking at financial metrics. For example, even if an investor has a high tolerance for risk during extremely uncertain times (like the current pandemic), he or she might opt for less volatile and safer investments. An investor might steer clear of stocks with high standard deviations from their average return, even if their calculations show the investment to offer an excellent average return. In addition, the expected return is calculated based on a stock’s past performance. However, suppose an investor knows a company that leads them to believe that, in the future, it will substantially outperform as compared to its historical norms. In that case, they might choose to invest in a stock that doesn’t appear all that promising from the expected return calculations.
The expected return is just one of the many tools used to evaluate an investment or portfolio of investments. A helpful financial metric to consider in addition to expected return is the return on investment ratio (ROI). This profitability ratio directly compares the value of increased profits a company has generated through capital investment in its business.
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