Finding the expected return of an asset involves calculating the probability of various possible outcomes based on historical rates of return. In other words, if history repeated itself, what are the chances of earning that profit on your investment? When you find the probability of several different return outcomes, combine them to find the total expected return. For example, suppose a fund had a 25% chance of a -3% return, a 50% chance of a 3% return, and a 25% chance of a 9% return. When you combine the chances of each scenario, your expected return is 3%. Learn how we got that number below.
How to Calculate Expected Return
To determine the expected return of an investment, you must use historical data to calculate the probability of certain events happening. For example, let’s say you want to find the expected return of a particular stock. Based on returns over the past 30 years, you know this stock has the following probability:
17% chance of a 3.5% return25% chance of a 5% return30% chance of a 6.5% return16% chance of an 8% return12% chance of a 9.5% return
To find the expected return of this stock, multiply each probability by the return with which it corresponds. Add together the results. Here’s how to calculate the expected return, E(R), of this stock:
E(R) = 0.17(.035) + 0.25(.05) + 0.30(.065) + 0.16(.08) + 0.12(.095)
When you multiply each possible return by its probability, you can simplify the calculation to:
E(R) = .00595 + .0125 + .0195 + .0128 + .0114
Add those numbers together, and you get 0.06215. Multiply that by 100 to get the percentage that is the expected return for the stock. In this example, the expected return for the stock is 6.22%. In addition to finding the expected return of a particular investment, you can also find it for your portfolio as a whole. To do so, you must find the weighted average expected return of all the assets in your portfolio, E(Rp). Here’s what that formula looks like:
E(Rp) = W1E(R1) + W2E(R2) + …
In this formula:
W = The weight of each asset, all of which must add up to 1E(R) = The expected return of each individual asset
For example, let’s say you have a portfolio made up of three different stocks. Stock A makes up 25% of your portfolio and has an expected return of 7%. Stock B makes up 40% of your portfolio and has an expected return of 5%. Stock C makes up 35% of your portfolio and has an expected return of 8.5%. To calculate the expected return of your portfolio, use the following calculation:
E(Rp) = 0.25(.07) + 0.40(.05) + 0.35(.085)
After multiplying and adding each together, you get 0.06725. Multiply by 100. The result shows an expected return of 6.73%. It’s important to note that the expected return of a particular asset can vary depending on how long you hold it. Global investment firm BlackRock compiles data on the expected return for a variety of assets. According to its data, the mean expected return on U.S. small-cap equities held for five years is 6.2% per year. But for those same equities held for 30 years, the mean expected return is 7.4% per year.
Pros and Cons of Knowing Expected Return
Expected return can be an effective tool for estimating your potential profits and losses on a particular investment. Before diving in, it’s important to understand the pros and cons.
Pros Explained
Helps an investor estimate their portfolio’s return: Expected return can be a useful tool in helping you understand how much you can expect to make from your current investments, based on historical performance. Can help guide an investor’s asset allocation: In addition to determining the potential return of a portfolio, you can use expected return to help guide your investment decisions. Return is a big factor investors often consider when choosing their investments. Knowing the expected return for each asset may help you decide where to put your money.
Cons Explained
Not a guarantee of actual returns: It’s very important investors using the expected-return formula understand what it is. Expected return is based on historical returns, but past performance doesn’t guarantee future performance. The expected return on any given asset or portfolio shouldn’t be the only thing you look at when making investment decisions. Doesn’t account for investment risk: The expected return of a particular investment doesn’t account for the level of risk that comes with it. In the case of high-risk investments, returns are often extreme in one way or the other—they can be very good or very bad. You can’t tell that from looking at the expected return. The difference in risk wouldn’t be apparent when comparing two investments of drastically different risk levels.
Alternatives to Expected Return
Expected return is one tool you can use to evaluate your portfolio or a potential investment, but it’s not the only one. There are other tools available that can help fill in some of the gaps the expected-return formula leaves.
Expected Return vs. Standard Deviation
Standard deviation is a measure of an investment’s risk level based on how far the return tends to fluctuate from its average. When a stock has a low standard deviation, its price stays relatively stable, and returns are usually close to the average. A high standard deviation indicates that a stock can be quite volatile. This means your returns have the potential to be significantly more or less than the average. The benefit of standard deviation is that, unlike expected return, it considers the risk associated with each investment. While expected return is based on the mean average return for a particular asset, standard deviation measures the likelihood of actually seeing that return.
Expected Return vs. Required Rate of Return
The required rate of return refers to the minimum return you would accept for an investment to be worth it. The required rate of return of an investment generally increases as the investment’s level of risk increases. For example, investors are often happy to accept a lower return on a bond than for a stock since bonds often present lower risk.
What It Means for Individual Investors
You can calculate the expected return of an individual investment or your entire portfolio. This information may help you understand potential returns before adding an investment to your portfolio. However, when it comes to using expected return to guide your investment decisions, it’s important to take what you find with a grain of salt. The expected return is based entirely on historical performance. There’s no guarantee that future returns will compare. It also doesn’t take into account the risk of each investment. The expected return of an asset shouldn’t be the only factor you consider when deciding to invest. Additionally, as the data from BlackRock showed, the expected return of an investment may vary substantially over time. While expected return might help long-term investors plan out their portfolios, it doesn’t apply as well for day traders.
