Definition
Expected return is a financial term used in investing that indicates the probable return on an investment. It represents the sum of the potential outcomes of an investment, each one weighted by its respective probability of occurring. It is calculated by multiplying the potential outcomes by the chances of them occurring, and then summing these results.
Phonetic
The phonetic pronunciation of “Expected Return” would be: /ɪkˈspɛktɪd rɪˈtɜrn/
Key Takeaways
Sure, here are the three main points about Expected Return in HTML numbered form:“`
- Expected Return is a concept in finance used to calculate the probable returns of an investment.
- It is based on the probability distribution of possible returns, computed by multiplying each potential outcome by the probability of its occurrence, then adding these up.
- While it provides an estimate of the expected profits or losses, the actual results can significantly vary due to unforeseen market conditions or events.
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Importance
The Expected Return is a critical concept in business and finance as it conveys the profit or loss an investor anticipates on an investment that has known or anticipated rates of return. It’s crucial in weighing the pros and cons of different investment opportunities and in determining the best possible option in alignment with investment goals. By understanding the expected return, investors can assess the potential risks involved, compare different investment scenarios, and formulate strategies to maximize their returns. It represents the average of all possible outcomes for the investment, weighted by their respective probabilities, providing valuable insight on the likelihood of achieving a given investment objective. This forms the basis for financial decision-making, risk management and portfolio optimization.
Explanation
In the financial and investment arenas, the Expected Return plays a pivotal role in helping investors anticipate and plan for the potential profitability of their investments. It provides a theoretical estimate of the amount of return likely to be generated on an investment or a portfolio. By using this tool, investors can form a fairly effective estimate of potential returns, allowing for strategic decision-making in terms of where to place their money for the best possible growth. It’s important to highlight that expected return, while based on historical data and logical assumptions, is predictive in nature and is not a guaranteed outcome.The Expected Return is an essential component of modern portfolio theory, allowing investors and financial analysts to calculate whether the potential return of an investment is sufficient to offset the risk associated with it. For example, in a stock investment scenario, investors would generally expect higher returns from stocks with a high level of risk than from those with lower risk. Therefore, the concept of expected return is used to help determine the proportion of different types of investments in a balanced portfolio, taking into account both the potential return and the risk level of each type. In a broader context, expected returns of different investment options are used by individuals, financial advisors, and institutional investors to facilitate the design of optimal investment strategies.
Examples
1. Stock Investment: Consider an investor who buys a stock from Company XYZ, which has a past record of generating a 12% return during good economic conditions and a -8% return during poor economic conditions. The investor estimates the chance of good economic conditions at 60% and poor conditions at 40%. The expected return would then be calculated as (0.6 x 12%) + (0.4 x -8%) = 4.8%. This means the investor expects to earn (on average) a return of 4.8% by investing in this stock.2. Mutual Funds: Assume an individual invests in a mutual fund with a track record of a 15% return in strong markets, a 5% return in average market conditions, and a -5% return in poor market conditions. If the individual estimates probabilities at 30% for a strong market, 50% for an average market, and 20% for a poor market, the expected return will be (0.15 x 30%) + (0.05 x 50%) + (-0.05 x 20%) = 6.5%. This is the annual rate of return the investor would expect from this mutual fund considering the associated risks and rewards.3. Real Estate Investment: Suppose an investor plans to invest in a property. The investor anticipated returns based on different scenarios: a 20% return if the local job market thrives and increases demands for homes, a 5% return if the local job market stays stable, and a 10% loss if the local market deteriorates. If the investor estimates probabilities at 40% for a thriving job market, 50% for a stable market, and 10% for a deteriorating market, the expected return would be calculated as (0.4 x 20%) + (0.5 x 5%) + (0.1 x -10%) = 9%. This indicates that on average, the investor can expect a 9% return on this real estate investment.
Frequently Asked Questions(FAQ)
What is Expected Return?
Expected Return is a concept in finance and investing that reflects the projected or anticipated amount of profit or loss an investment might generate. It essentially gives an investor an estimate of what the return on an investment might be, based on historical data or calculated probabilities.
How is Expected Return calculated?
The Expected Return of an investment can be calculated using the formula: Expected Return = Sum of (Probability of each outcome * Corresponding return for each outcome). Here, each outcome refers to the outcome of each potential investment scenario, while the probability is the estimation of that specific outcome happening.
Why is Expected Return important?
Expected Return is a vital concept as it provides an investor with a measure to anticipate the profits or losses from an investment. It helps in evaluating the risk and return of different investments and can guide decision-making in investment portfolios.
Is a higher Expected Return always better?
A higher Expected Return might seem attractive as it suggests potential for higher profits. But it’s important to note that higher expected returns often come with higher risk. Therefore, it’s crucial to examines both the return and associated risk level while considering an investment.
How does Expected Return relate to Risk?
There is generally a positive correlation between risk and expected return in finance. Investments with higher expected returns usually come with higher levels of risk. This risk represents the uncertainty or variability in the investment’s returns.
Does the Expected Return guarantee actual return?
No, the Expected Return is simply a prediction or estimate made based on historical returns or potential outcomes. It does not guarantee that the investment will definitely yield the estimated return, as actual return can be affected by many unpredictable factors and market conditions.
How can we use Expected Return in diversifying an investment portfolio?
Expected Return, when used alongside other parameters such as risk and correlation, can help in building a diversified portfolio to balance risk and return. It helps in choosing a collection of assets that could maximize return for a given level of risk.
Does Expected Return consider the time value of money?
The basic principle of Expected Return doesn’t account for the time value of money. However, you can use adjusted versions such as expected return on investment, which do factor in the time value of money.
Related Finance Terms
- Risk-Adjusted Return
- Portfolio Return
- Standard Deviation
- Return on Investment (ROI)
- Variance
Sources for More Information
