Expected return

Definition

Expected return is the anticipated return on an investment, calculated as the weighted average of all possible returns, considering their probabilities. This concept helps investors make informed decisions by estimating potential gains or losses over a specific period. It serves as a crucial factor in portfolio management and financial optimization, guiding choices based on risk-reward profiles.

5 Must Know Facts For Your Next Test

1. Expected return is typically expressed as a percentage, representing the average outcome based on probabilities.
2. The formula for expected return combines the possible returns multiplied by their respective probabilities: $$E(R) = \sum (P_i \times R_i)$$, where $$P_i$$ is the probability of each return and $$R_i$$ is the return associated with that probability.
3. Investors often compare the expected return with the risk associated with an investment to assess its attractiveness.
4. Higher expected returns usually come with higher levels of risk, creating a trade-off that investors must navigate.
5. In financial optimization problems, expected return helps determine the most efficient asset allocation to achieve desired investment goals.

Review Questions

• How does expected return play a role in investment decision-making and portfolio management?
  • Expected return plays a critical role in investment decision-making by helping investors assess the potential profitability of various assets. By calculating the anticipated returns, investors can prioritize investments that align with their financial goals and risk tolerance. In portfolio management, understanding expected return aids in determining the optimal mix of assets that balances potential gains with acceptable levels of risk.
• Analyze how the concept of risk interacts with expected return when making investment choices.
  • The concept of risk is intrinsically linked to expected return, as higher potential returns are often accompanied by increased risk. Investors must weigh this trade-off carefully when selecting investments. Understanding how risk influences expected return helps them identify investments that not only promise good returns but also align with their risk appetite, leading to more informed and strategic investment choices.
• Evaluate the implications of using expected return as a metric in financial optimization problems, especially concerning diversification strategies.
  • Using expected return as a metric in financial optimization problems can significantly impact diversification strategies. When constructing a diversified portfolio, investors aim to maximize expected returns while minimizing risk through asset allocation. By analyzing the expected returns of various assets, investors can strategically diversify their portfolios to enhance overall performance while reducing volatility, thus leading to more stable long-term growth.

Related terms

Risk: The potential for loss or gain on an investment, often associated with the uncertainty of the expected return.

Portfolio: A collection of financial investments like stocks, bonds, and cash equivalents held by an individual or institution.

Diversification: A risk management strategy that mixes a wide variety of investments within a portfolio to reduce exposure to any single asset.