What is 'Expected Return'
Expected return is the amount of profit or loss an investor anticipates on an investment that has various known or expected rates of return. It is calculated by multiplying potential outcomes by the chances of them occurring, and summing these results. For example, if an investment has a 50% chance of gaining 20% and a 50% change of losing 10%, the expected return is (50% x 20% + 50% x -10%), or 5%.
BREAKING DOWN 'Expected Return'Expected return is usually based on historical data and is not guaranteed. For the most part, the expected return is a tool used to determine whether or not an investment has a positive or negative average net outcome. In the example above, for instance, the 5% expected return may never be realized in the future; it is merely an average of what may occur. In addition to expected return, wise investors should also consider the probability of return in order to properly assess risk. After all, one can find instances in which certain lotteries offer a positive expected return, despite the very low probability of realizing that return.
Expected Return of a Portfolio
The expected return doesn't just apply to single investments. It can also be analyzed for a portfolio containing many investments. If the expected return for each investment is known, the portfolio's overall expected return is simply a weighted average of the expected returns of its components. For example, assume the following portfolio of stocks:
Stock A: $500,000 invested and an expected return of 15%
Stock B: $200,000 invested and an expected return of 6%
Stock C: $300,000 invested and an expected return of 9%
With a total portfolio value of $1,000,000, the weight's of Stock A, B and C are 50%, 20% and 30%. Thus, the expected return of the total portfolio is:
Expected return of portfolio = (50% x 15%) + (20% x 6%) + (30% x 9%) = 7.5% + 1.2% + 2.7% = 11.4%
Risk Must Also Be Analyzed
It is quite dangerous to make investment decisions based on expected returns alone. Investors should always review the risk characteristics of investment opportunities before making any buying decisions, to determine if the investments align with their portfolio goals. For example, assume two hypothetical investments exist. Their annual performance results for the last five years are:
Investment A: 12%, 2%, 25%, -9%, 10%
Investment B: 7%, 6%, 9%, 12%, 6%
Both of these investments have expected returns of exactly 8%. But when analyzing the risk of each, as defined by standard deviation, Investment A is approximately five times more risky than Investment B (Investment A has a standard deviation of 12.6% and Investment B has a standard deviation of 2.6%).