Expected return

Definition

Expected return is the anticipated profit or loss from an investment, calculated as a weighted average of all possible returns, each multiplied by its probability of occurrence. This concept is crucial for investors as it helps them gauge potential gains against risks, forming the foundation for investment decisions. The expected return is often used in assessing different investment options and is essential for understanding how risk influences potential rewards.

5 Must Know Facts For Your Next Test

1. The expected return is expressed as a percentage and can be calculated using historical data or projected future returns.
2. Investors often compare the expected return of different assets to make informed decisions about where to allocate their capital.
3. The calculation of expected return considers both positive and negative outcomes, making it a more comprehensive measure than just looking at average historical returns.
4. Higher expected returns are typically associated with higher levels of risk, reflecting the risk-return tradeoff in investing.
5. Expected return plays a critical role in portfolio management as it aids in constructing optimal portfolios by aligning risk tolerance with anticipated returns.

Review Questions

• How is expected return calculated and why is it important for investors?
  • Expected return is calculated by taking all possible returns from an investment, multiplying each by the probability of its occurrence, and summing these values. This calculation provides investors with a clear picture of potential profitability and helps them assess whether the investment aligns with their financial goals and risk tolerance. Understanding expected return enables investors to make more informed decisions when comparing various investment opportunities.
• Discuss the relationship between expected return and risk in the context of investment choices.
  • Expected return and risk are closely related in investing, as higher potential returns usually come with increased risks. Investors use expected return as a benchmark to evaluate whether the risks associated with an investment are justified by the potential rewards. This relationship underscores the importance of risk assessment when constructing portfolios and making strategic investment choices.
• Evaluate how expected return impacts portfolio diversification strategies in investment management.
  • Expected return significantly influences portfolio diversification strategies as investors seek to optimize their portfolios by balancing risk and reward. By calculating the expected return for various assets, investors can identify combinations that enhance overall portfolio performance while minimizing risks. Effective diversification aims to achieve a desirable level of expected return without taking on excessive risk, ultimately leading to more stable long-term financial outcomes.

Related terms

Risk Premium: The additional return an investor expects to receive from an investment over the risk-free rate, compensating for the risk taken.

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

Capital Asset Pricing Model (CAPM): A model that describes the relationship between systematic risk and expected return, used to price risky securities.