Expected Return

Definition

Expected return is the anticipated profit or loss from an investment, calculated as a weighted average of all possible returns, with probabilities assigned to each outcome. It reflects the investor's expectations about the future performance of an asset and is crucial for assessing risk and making informed investment decisions.

5 Must Know Facts For Your Next Test

1. Expected return can be computed using historical data or forecasts of future performance, and is often expressed as a percentage.
2. It plays a key role in portfolio optimization by helping investors select assets that align with their risk tolerance and investment goals.
3. Investors use expected return to evaluate whether an investment is worth the risk compared to other opportunities.
4. The accuracy of expected return calculations heavily relies on the reliability of the input probabilities and possible returns.
5. Different assets may have varying expected returns based on market conditions, economic indicators, and individual asset characteristics.

Review Questions

• How does understanding expected return help investors make decisions about their investment portfolios?
  • Understanding expected return allows investors to evaluate potential investments based on anticipated profits relative to risks. By calculating expected returns for various assets, investors can compare them and choose those that best align with their financial goals and risk tolerance. This informed decision-making is essential in constructing a balanced portfolio that seeks to maximize returns while managing overall risk.
• Discuss how variance relates to expected return in the context of evaluating investment risks.
  • Variance provides insight into the level of risk associated with an investment by measuring how much actual returns deviate from the expected return. A higher variance indicates more uncertainty and potential volatility in returns, which can affect an investor's perception of risk. Therefore, when considering investments, it is essential to analyze both expected return and variance together to determine if the potential rewards justify the risks involved.
• Evaluate how changes in market conditions might impact the expected return of an asset and overall investment strategies.
  • Changes in market conditions, such as economic downturns or shifts in interest rates, can significantly impact an asset's expected return by altering its risk profile and cash flow projections. For instance, during economic growth, expected returns might increase due to higher consumer spending. Conversely, during a recession, expected returns may decline as companies face lower revenues. Investors must continually reassess their strategies based on these changing conditions to ensure they are achieving their desired balance of risk and reward in their portfolios.

Related terms

Risk Premium: The additional return expected from an investment in a risky asset over the risk-free rate.

Variance:

A statistical measure that represents the dispersion of returns around the expected return, indicating the level of risk associated with an investment.

Capital Asset Pricing Model (CAPM):

A model used to determine the expected return on an asset based on its systematic risk, represented by beta, and the expected market return.