Loading the player...

What is 'Expected Return'

Expected return is the profit or loss an investor anticipates on an investment that has known or expected rates of return. It is calculated by multiplying potential outcomes by the chances of them occurring and then 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% * 20% + 50% * -10%), or 5%.

BREAKING DOWN 'Expected Return'

Expected return is a tool used to determine whether an investment has a positive or negative average net outcome. It's calculated as the expected value of an investment given its potential returns in different scenarios, as illustrated by the following formula:

Expected Return = SUM (Returni * Probabilityi), where i indicates each known return and its respective probability in the series.

Expected return is usually based on historical data and is therefore not guaranteed; it is merely a long-term weighted average of historical returns. In the example above, for instance, the 5% expected return may never be realized in the future, as the investment is inherently subject to systematic and unsystematic risks.

In addition to expected returns, wise investors should also consider the probability of return in order to better 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 expanded to analyze a portfolio containing many investments. If the expected return for each investment is known, the portfolio's overall expected return is 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 weights of Stock A, B and C are 50%, 20% and 30%, respectively. 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%

Limitations of the Expected Return

It is quite dangerous to make investment decisions based on expected returns alone. Before making any buying decisions, investors should always review the risk characteristics of investment opportunities 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%. However, when analyzing the risk of each, as defined by the 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%).

See Expected Return, Variance and Standard Deviation of aPortfolio for more on calculating and analyzing these statistical measures.

RELATED TERMS
  1. Mean Return

    1. In securities analysis, it is the expected value, or mean, ...
  2. Annualized Total Return

    Annualized total return gives the yearly return of a fund calculated ...
  3. Return

    A return, in finance, is the profit or loss derived from investing ...
  4. Modern Portfolio Theory - MPT

    A theory on how risk-averse investors can construct portfolios ...
  5. Negative Return

    A negative return occurs when a company or business has a financial ...
  6. Actual Return

    Actual return refers to the de facto gain or loss an investor ...
Related Articles
  1. Investing

    Explaining Expected Return

    The expected return is a tool used to determine whether or not an investment has a positive or negative average net outcome.
  2. Investing

    Understanding The Sharpe Ratio

    The Sharpe ratio describes how much excess return you are receiving for the extra volatility that you endure for holding a riskier asset.
  3. Investing

    The Uses And Limits Of Volatility

    Check out how the assumptions of theoretical risk models compare to actual market performance.
  4. Financial Advisor

    Measure your portfolio's performance

    Measure the success of your investment solely on the portfolio return may leave you blindsided to the risk you are taking. Learn three ratios that will help you evaluate your investment return. ...
  5. Investing

    Understanding Quantitative Analysis Of Hedge Funds

    Analyzing hedge fund performance quantitatively requires metrics such as absolute and relative returns, risk measurement, and benchmark performance ratios.
  6. Investing

    How to Calculate Your Investment Return

    How much are your investments actually returning? The method of calculation can make a significant difference in your true rate of return.
  7. Investing

    Returns and Financial Planning Projections

    Return expectations continue to be a necessary part of any investment strategy discussion.
  8. Investing

    What Returns Can You Expect in the Stock Market?

    Looking at the historical returns of the stock market helps you understand current stock returns.
  9. Personal Finance

    The 5 Faults of Filtering by Historical Returns

    Why you shouldn't use past performance to filter out potential financial advisors.
RELATED FAQS
  1. How can I calculate the expected return of my portfolio?

    Understand the components of the equation used to calculate the expected return of an investor's portfolio. Learn why the ... Read Answer >>
  2. What is a good annual return for a mutual fund?

    Learn the key factors that determine if a mutual fund's return is "good" for you and your needs? Read Answer >>
  3. What is the difference between a sharpe ratio and an information ratio?

    Understand the meaning of the Sharpe ratio and the information ratio, and understand how they differ as tools for evaluating ... Read Answer >>
  4. What does standard deviation measure in a portfolio?

    Dig deeper into the investment uses of and mathematical principles behind standard deviation as a measurement of portfolio ... Read Answer >>
  5. How is standard deviation used to determine risk?

    Understand the basics of calculation and interpretation of standard deviation, and how it is used to measure and determine ... Read Answer >>
Hot Definitions
  1. Receivables Turnover Ratio

    Receivables turnover ratio is an accounting measure used to quantify a firm's effectiveness in extending credit and in collecting ...
  2. Treasury Yield

    Treasury yield is the return on investment, expressed as a percentage, on the U.S. government's debt obligations.
  3. Return on Assets - ROA

    Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets.
  4. Fibonacci Retracement

    A term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going ...
  5. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  6. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
Trading Center