A well-informed investor wants to know the expected return of his portfolio. Knowing the expected return can help an investor prepare for various outcomes based on all available information.
What is Expected Return?
Expected return is the anticipated profit or loss from an investor's portfolio. Investors use expected return as a way of preparing for likely future outcomes. Expected return is just that: expected. It is not guaranteed, as it is based on historical returns and used to generate expectations, but it is not a prediction.
How to Calculate Expected Return
To calculate the expected return of a portfolio, an investor needs to add up the weighted averages of each security's expected returns. The equation for the expected return of a portfolio with three securities is as follows:
Expected return = (weight of security A) x (expected return of security A) + (weight of security B) x (expected return of security B) + (weight of security C) x (expected return of security C)
To calculate the expected return of an investor's portfolio, the investor needs to know the expected return of each of the securities in his portfolio as well as the overall weight of each security in the portfolio.
Expected return is based on historical data, so investors should take into consideration the likelihood that each security will achieve its historical return given the current investing environment. Some assets, like bonds, are more likely to match their historical returns, while others, like stocks, may vary more widely from year to year. A lottery, for instance, may have a high expected return but a low probability of achieving it.
Past and Future Returns
An investor bases the estimates of the expected return of a security on the assumption that what has been proven true in the past will continue to be proven true in the future. The investor does not use a structural view on the market to calculate the expected return. He finds the weight of each security in the portfolio by taking the value of each of the securities and dividing it by the total value of the security.
Once the expected return of each security is known and the weight of each security has been calculated, an investor simply multiplies the expected return of each security by the weight of the same security, and adds up the product of each security.
Since the market is volatile and unpredictable, calculating the expected return of a security is more guesswork than definite, and it could cause inaccuracy in the calculated expected return of a portfolio.
Limitations of Expected Return
Expected returns so not paint a complete picture, so making investment decisions based on them alone can be dangerous. For instance, expected returns do not take volatility 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 backward looking, they do not factor in current market conditions, political environment, legal and regulatory changes, and other factors.