Expected Return

Definition

Expected return is the anticipated return on an investment or asset based on the probabilities of possible outcomes. It plays a vital role in both engineering and finance as it helps in decision-making, risk assessment, and performance evaluation by quantifying the average return one can expect from an investment over time. Understanding expected return allows investors and engineers to evaluate projects, allocate resources effectively, and balance risks against potential rewards.

5 Must Know Facts For Your Next Test

1. Expected return is calculated using a weighted average of all possible returns, where each return is weighted by its probability of occurrence.
2. In finance, expected return is often used to compare different investment options, helping investors choose where to allocate their capital.
3. Engineers use expected return to evaluate the profitability of projects, considering factors such as costs, benefits, and associated risks.
4. The concept of expected return can be applied to different time frames, allowing for better long-term strategic planning in both finance and engineering.
5. In practice, actual returns can vary significantly from expected returns due to unforeseen events, highlighting the importance of risk management.

Review Questions

• How do engineers utilize expected return in project evaluation and resource allocation?
  • Engineers utilize expected return by calculating the anticipated financial benefits of a project against its costs and risks. This involves estimating various potential outcomes and assigning probabilities to them, which helps in determining whether a project is worth pursuing. By comparing the expected return to other investment opportunities or projects, engineers can make informed decisions about where to allocate resources for maximum effectiveness.
• Discuss how understanding expected return contributes to effective risk management in finance.
  • Understanding expected return is crucial for effective risk management in finance because it enables investors to quantify potential gains against associated risks. By analyzing the expected return alongside its variance or standard deviation, investors can gauge how much risk they are taking relative to the potential reward. This helps them build diversified portfolios that align with their risk tolerance while aiming for optimal returns, ultimately leading to more strategic investment decisions.
• Evaluate the impact of unexpected events on actual returns compared to expected returns in financial markets.
  • Unexpected events can significantly impact actual returns by causing deviations from what was anticipated based on expected return calculations. For instance, market volatility due to economic changes, natural disasters, or geopolitical tensions can lead to drastic shifts in asset prices, affecting the returns investors ultimately receive. This divergence emphasizes the importance of incorporating robust risk assessment techniques and flexibility in investment strategies, allowing for adjustments when actual returns deviate from expectations.

Related terms

Variance: A statistical measurement that describes the spread of returns around the expected return, indicating the level of risk associated with an investment.

Risk-Return Tradeoff: The principle that potential return rises with an increase in risk; a higher expected return typically comes with greater risk.

Portfolio Theory: An investment theory that focuses on maximizing returns by diversifying investments across various assets to manage risk.