What is Expected Return?
The expected return means the profit or loss anticipated by an investor on an investment that has known or expected return rates. This can be calculated by multiplying potential outcomes by the likelihood that they will occur and then adding up the results.
Consider that an investment has about 50% chance of gaining 20% and another 50% chance of losing 10%. The expected return here is 5%. That is, (50%x 20% + 50%x -10%) = 5%
How Expected Returns Work
The expected return is a measure that is used to determine whether the average net result of an investment is positive or negative. The sum is calculated as an investment's expected value (EV) due to its potential returns as seen in different scenarios.
The same is illustrated using the formula below: Expected Return = SUM (Returni x Probabilityi) Where i indicates each known return and the corresponding probability in the series
Dependence on Historical Data
Usually, the expected return is based on historical data and therefore, is not guaranteed. This figure is merely a weighted long-term historical return average.
Considering the above example, the expected return of 5% may never come true because the investment is subject to systematic and unsystematic risks. Here, systematic risk is the danger to a market sector or the entire market itself, whereas unsystematic risk is limited to a particular company or industry.
Limitations
It is not practical to make investment decisions based on the expected returns factor alone. Before making any buying decisions, investors must review the risks associated with investment opportunities to determine if the investments align with their portfolio goals.
In addition to expected returns, the likelihood of a return to better assess risk should also be considered by wise investors. After all, one can find instances where, despite the very low chances of realising that return, some lotteries offer a positive expected return.
