Definition
The expected return is the profit or loss that an investor anticipates on an investment based on known historical rates of return (RoR). It is calculated by multiplying potential outcomes by the probabilities of them occurring and then summing these results. The expected return provides a measure for making financial decisions, even though it does not offer guaranteed results.
Expected Return vs Actual Return
| Term |
Definition |
| Expected Return |
The forecasted profit or loss of an investment, calculated using probabilities of various outcomes. |
| Actual Return |
The realized profit or loss from an investment, which may differ from the expected return due to unpredicted events. |
Examples
-
Example of Expected Return Calculation:
Suppose you have two possible outcomes for an investment:
- Outcome A: 30% chance of earning $200
- Outcome B: 70% chance of losing $50
The expected return can be calculated as:
\[
Expected,Return = (0.30 \times 200) + (0.70 \times -50) = 60 - 35 = 25
\]
Therefore, the expected return is $25.
-
Portfolio Expected Return:
If an investor has a portfolio consisting of:
- Stock A with an expected return of 10% and weight of 60%
- Stock B with an expected return of 5% and weight of 40%
The portfolio expected return can be calculated as:
\[
Expected,Return_{Portfolio} = (0.60 \times 10) + (0.40 \times 5) = 6 + 2 = 8%
\]
- Return on Investment (RoI): A measure of the profitability of an investment calculated as the net profit divided by the initial cost.
- Risk: The potential for loss or lower-than-expected returns on investments.
- Diversification: The practice of spreading investments across various assets to reduce risk.
Interesting Insights & Humorous Citations
- “Investing is like a marriage: often, you’ll love it, but sometimes you’ll want to run away—and that’s just the expected return talking!” 😂
- It’s said that “the stock market is filled with individuals who know the price of everything, but the value of nothing.” Wise words, especially when evaluating expected returns! 🧐
Frequently Asked Questions
-
What is the difference between expected return and actual return?
Expected return is what you anticipate based on probabilities, while actual return is what you really earn (or lose).
-
Can expected returns guarantee profits?
No, expected returns are helpful for estimating potential outcomes but do not guarantee specific results. The market remains unpredictable! 🎢
-
How do I calculate expected return for a portfolio?
Use a weighted average formula, considering each investment’s expected return and its proportion in the portfolio.
Further Reading & Resources
- Investopedia - A comprehensive overview of expected return.
- Books:
- “The Intelligent Investor” by Benjamin Graham - A classic read on investing strategies and expected returns.
- “A Random Walk Down Wall Street” by Burton Malkiel - A great servant to help understand market behavior and expected returns.
pie
title Expected Return Scenarios
"Profit (80%)": 80
"Loss (20%)": 20
Test Your Knowledge: Expected Return Challenge Quiz
## What does "expected return" mean in investing?
- [x] The potential profit or loss anticipated from an investment
- [ ] The sum of all investments made
- [ ] The highest possible profit obtainable
- [ ] The stock price at the time of purchase
> **Explanation:** The expected return refers to the profit or loss an investor anticipates from an investment based on historical data and probabilities.
## How do you calculate expected return?
- [x] Multiply possible outcomes by their probabilities and sum the results
- [ ] Divide the total investment by the highest profit
- [ ] Add the current share price to the predicted future price
- [ ] Calculate the average of historical returns only
> **Explanation:** You calculate expected return by multiplying each possible outcome by its probability and summing the results.
## If you have a 50% chance to gain $100 and a 50% chance to lose $50, what is your expected return?
- [ ] $50
- [ ] $25
- [x] $25
- [ ] $0
> **Explanation:** Expected Return = (0.5 * 100) + (0.5 * -50) = 50 - 25 = $25.
## What does diversifying a portfolio affect in terms of expected return?
- [x] It reduces risk but may impact overall expected return
- [ ] It guarantees higher returns
- [ ] It creates a lower risk of total loss
- [ ] It increases predicted loss
> **Explanation:** Diversification can lower risk, but it varies how it impacts expected returns based on asset performance.
## True or False: Expected return can provide guaranteed outcomes.
- [ ] True
- [x] False
> **Explanation:** Expected return is merely a forecast; it cannot guarantee specific outcomes, as markets can be unpredictable.
## In portfolio management, expected return is calculated as:
- [ ] The average of the best and worst investments
- [ ] The highest return among the assets
- [x] A weighted average of the expected returns of individual investments
- [ ] A fixed percentage based on historical data
> **Explanation:** The expected return of a portfolio is the weighted average of the expected returns from each investment.
## When would an investor consider their actual return not meeting their expected return?
- [ ] Always
- [ ] Never
- [x] When the outcome was less than anticipated
- [ ] Only in a bull market
> **Explanation:** An investor may find that their actual return is less than the expected return if the market behaves unpredictably.
## Which term describes the risk an investor must consider in relation to expected return?
- [ ] Historical Performance
- [x] Volatility
- [ ] Discount Rate
- [ ] News Reports
> **Explanation:** Volatility reflects how much returns can fluctuate, influencing the expected return's reliability.
## Why might investors use expected return calculations?
- [x] To assess the viability of potential investments
- [ ] To determine current market worth
- [ ] To calculate tax obligations
- [ ] All of the above
> **Explanation:** Investors use expected returns primarily to distill insights into the potential success of an investment.
## Which factor does NOT affect expected return calculations?
- [x] Local weather conditions
- [ ] Market conditions
- [ ] Investment type
- [ ] Probabilities of outcomes
> **Explanation:** Local weather conditions don't impact expected return; other factors such as market conditions, investment type, and outcome probabilities are critical.
Thank you for exploring the delightful world of Expected Returns! Remember, they may not guarantee profits, but they certainly help bring clarity to investment decisions. Keep smiling and investing wisely! 🌟
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