Expected return

Definition

Expected return is the anticipated return on an investment, calculated as the weighted average of all possible outcomes, each multiplied by its probability. This concept is crucial in assessing investment performance and helps investors make informed decisions regarding risk and reward by providing a benchmark for evaluating potential investments against their risk profile.

5 Must Know Facts For Your Next Test

1. Expected return is often represented as a percentage and incorporates both historical data and future projections to estimate potential performance.
2. It is essential for investors to understand that expected return does not guarantee actual returns, which can be influenced by various market factors.
3. In finance, expected return is calculated using the formula: $$E(R) = \sum (P_i \times R_i)$$, where P represents the probability of each outcome and R represents the return of each outcome.
4. The expected return helps investors assess whether an investment aligns with their financial goals and risk tolerance, influencing asset allocation decisions.
5. Different assets have different expected returns based on their inherent risk levels, with higher risk typically associated with higher expected returns.

Review Questions

• How does expected return assist investors in making informed investment decisions?
  • Expected return helps investors evaluate the potential profitability of various investments by providing a forecast based on historical performance and projected outcomes. By understanding the expected returns associated with different assets, investors can weigh their options against their own risk tolerance and financial objectives. This insight allows them to make better choices when constructing their portfolios or deciding between competing investment opportunities.
• Discuss the relationship between expected return and risk premium, including how they influence investment strategy.
  • Expected return and risk premium are closely linked, as the risk premium represents the additional return an investor anticipates for bearing extra risk beyond that of a risk-free asset. When formulating an investment strategy, understanding this relationship allows investors to make more informed decisions about where to allocate their capital. By comparing the expected returns across different assets while considering their respective risks, investors can identify opportunities that align with their desired balance of risk and reward.
• Evaluate how the Capital Asset Pricing Model (CAPM) integrates expected return into its analysis of investment risk.
  • The Capital Asset Pricing Model (CAPM) uses expected return as a key component in evaluating the relationship between an asset's anticipated return and its systematic risk, measured by beta. This model posits that the expected return of an asset should equal the risk-free rate plus the product of its beta and the market risk premium. By incorporating expected return into its framework, CAPM provides a method for assessing whether an asset is fairly valued given its level of risk. This enables investors to identify potentially mispriced assets and make more strategic investment choices based on their expectations.

Related terms

Risk premium: The additional return expected by an investor for taking on additional risk compared to a risk-free investment.

Portfolio: A collection of financial assets, such as stocks, bonds, and cash equivalents, held by an investor to diversify risk and optimize returns.

Capital Asset Pricing Model (CAPM): A model that establishes a linear relationship between the expected return of an asset and its systematic risk, often used to determine a theoretically appropriate required rate of return.