Expected Return
Expected Return
The expected return on an investment is the average return that an investor can expect to receive from an investment over a given period of time. It is calculated by taking the weighted average of the possible returns of the investment, where the weights are the probabilities of each return occurring.
Formula:
Expected Return = ฮฃ(Return * Probability)
where:
- ฮฃ is the sum of the products of each return and its probability
- Return is the possible return
- Probability is the probability of each return occurring
Factors Affecting Expected Return:
- Risk profile of the investment: Investments with higher risk typically have higher expected returns.
- Market conditions: Economic factors, interest rates, and inflation can affect expected returns.
- Company fundamentals: For company stocks, factors such as revenue growth, profitability, and market share can impact expected returns.
- Investment horizon: The longer the investment horizon, the higher the expected return.
- Fees and expenses: Any fees or expenses associated with the investment can reduce the expected return.
Examples:
1. Calculating the expected return of a stock:
- Possible returns: 10%, 15%, 20%
- Probabilities of each return: 20%, 50%, 30%
Expected Return = (10% * 0.2) + (15% * 0.5) + (20% * 0.3) = 15%
2. Calculating the expected return of a bond:
- Coupon rate: 2%
- Probability of default: 0.05%
Expected Return = 2% + (0.05% * -10%) = 2.00%
Conclusion:
Expected return is a key concept in investing. It helps investors make informed decisions about how to allocate their money and can be used to compare different investments. By considering the factors that affect expected return, investors can make more effective decisions and achieve their financial goals.
