What is the Expected Return? How to use?

What is expected return is the profit or loss an investor expects from an investment with known historical rates of return (RoR). It is calculated by multiplying the possible outcomes by their chances of occurring and then adding these outcomes together.

How to Calculate Expected Return?

Expected return calculations are an important part of both business operations and financial theory, including the well-known models of modern portfolio theory (MPT) or the option pricing model. For example, if an investment has a 50% chance of winning 20% ​​and a 50% chance of losing 10%, the expected return is 5%= (50% x 20% + 50% x -10%= 5%).

Expected return is a tool used to determine whether the average net result of an investment is positive or negative. The total is calculated as the expected value of an investment, taking into account its potential returns in different scenarios, as shown by the formula below:

Expected Return = Σ (Return ix Probability i )

“i” indicates each known spin in the series and its associated probability.

The expected return is usually based on historical data. Therefore, it is not guaranteed for the future but generally sets reasonable expectations. Therefore, the expected return figure can be thought of as the long-term weighted average of historical returns.

For example, in the above formulation, the expected return of 5% may never be realized in the future as the investment is inherently subject to systematic and unsystematic risks. Systematic risk is the danger to a market sector or the entire market, while unsystematic risk applies to a specific company or industry.

Considering individual investments or portfolios, a more formal equation for the expected return on a financial investment is:

Expected return = Risk-free premium + Beta (expected market return – risk-free premium)

In essence, this formula states that the expected return in excess of the risk-free rate of return depends on the investment’s beta, or its relative volatility compared to the broader market.

Expected return and standard deviation are two statistical measures that can be used to analyze a portfolio. The expected return on a portfolio is the expected amount of return that portfolio can produce. This makes it the average of the portfolio’s possible return distribution. The standard deviation of a portfolio represents the risk of the portfolio by measuring how much the returns deviate from its average.

What Are Expected Return Limitations?

It would not be healthy to make investment decisions based solely on expected return calculations. Before making any investment decision, the compatibility of investments with portfolio objectives should be checked. You should also review the risk characteristics of investment opportunities.

For example, let’s say there are two hypothetical investments. Annual performance results for the last five years:

• Investment A: 12%, 2%, 25%, -9% and 10%
• Investment B: 7%, 6%, 9%, 12% and 6%

Both of these investments expected returns of exactly 8%. But when analyzing the risk of each, defined by standard deviation, investment A is approximately five times riskier than investment B. That is, the standard deviation of investment A is 11.26% and the standard deviation of investment B is 2.28%. Standard deviation is a common statistical measurement used to measure the historical volatility or risk of an investment.

In addition to expected returns, investors should also consider the possibility of these returns. After all, there may be cases where certain lotteries offer a positive expected return, even though the chances of realizing that return are very low.

How to Use Expected Return in Finance?

Expected return calculations are an important part of both trading activities and financial theory, including the well-known modern portfolio theory (MPT) models or the Black-Scholes option pricing model. It is a tool used to determine whether an investment has a positive or negative average net result.