Expected Return

Definition

Expected return is the anticipated profit or loss an investor anticipates on an investment over a specified period, often expressed as a percentage. This concept is fundamental in finance as it helps investors evaluate the potential profitability of various investment opportunities while considering associated risks. Understanding expected return allows investors to make informed decisions by comparing different assets and strategies.

5 Must Know Facts For Your Next Test

1. Expected return is calculated using probabilities and potential outcomes of various investment scenarios, often represented mathematically as the weighted average of all possible returns.
2. In the Capital Asset Pricing Model (CAPM), expected return is directly related to the risk-free rate and the asset's beta, which measures its volatility relative to the market.
3. Higher expected returns typically come with higher levels of risk, illustrating the risk-return tradeoff that is central to investment decisions.
4. Marginal cost of capital influences expected return calculations, as it represents the cost of obtaining additional capital, impacting how much investors expect to earn on new investments.
5. Investors often use historical data to estimate future expected returns, though these estimates can be affected by market conditions and economic factors.

Review Questions

• How does expected return relate to the concept of risk in investment decisions?
  • Expected return is closely tied to the concept of risk, as it helps investors gauge potential rewards against possible losses. Generally, investments with higher expected returns carry greater risks, compelling investors to assess their risk tolerance. This relationship emphasizes the risk-return tradeoff, where an investor must decide how much risk they are willing to take for the chance of achieving higher returns.
• In what ways does the Capital Asset Pricing Model (CAPM) utilize expected return in its calculations?
  • The Capital Asset Pricing Model (CAPM) uses expected return as a key component to evaluate whether an asset is fairly priced based on its systematic risk. The model incorporates the risk-free rate and adds a risk premium that is determined by multiplying the asset's beta by the market risk premium. By comparing expected returns calculated through CAPM against actual returns, investors can assess if an investment aligns with their required rate of return given its associated risks.
• Evaluate how changes in economic conditions can affect an investor's estimation of expected return and what strategies can be employed to mitigate this uncertainty.
  • Economic conditions such as interest rates, inflation, and overall market performance significantly influence an investor's estimation of expected return. For instance, rising interest rates may lead to lower expected returns on bonds, while economic downturns can diminish anticipated returns across various asset classes. To mitigate this uncertainty, investors can diversify their portfolios, employing strategies like asset allocation across different sectors or geographic regions to balance risks and improve potential returns in fluctuating economic environments.

Related terms

Risk Premium: The additional return an investor expects to earn from an investment in a risky asset compared to a risk-free asset.

Discount Rate: The interest rate used to determine the present value of future cash flows, reflecting the opportunity cost of capital.

Portfolio Return: The overall return expected from a collection of investments, taking into account the individual expected returns and their respective weights in the portfolio.