Expected results

What Is Expected Return?

Expected return is a financial metric representing the anticipated profit or loss on an investment over a specific period, based on historical data or estimated probabilities. It is a fundamental concept within Portfolio Theory, providing a forward-looking estimate rather than a guarantee of future performance. Investors and financial analysts utilize expected return to evaluate potential Investment Decisions, compare different assets, and construct portfolios aimed at achieving specific financial objectives. While expected return does not guarantee actual outcomes, it offers a reasoned forecast that helps in assessing the risk-reward tradeoff of various investment opportunities²¹.

History and Origin

The concept of anticipating future financial outcomes has ancient roots, with early societies using basic mathematical models to predict agricultural yields and plan economic activities¹⁹, ²⁰. However, the formal integration of expected returns into modern financial theory is largely attributed to the mid-20th century. A pivotal development came with Harry Markowitz's work, which laid the foundation for Modern Portfolio Theory (MPT). In his 1952 paper, "Portfolio Selection," Markowitz introduced the idea that investors should consider not just the expected value of assets but also their risk, leading to the development of a framework that mathematically trades off risk tolerance and reward expectations¹⁸. This marked a significant shift towards a more quantitative approach to investment analysis and Financial Forecasting.

Key Takeaways

• Expected return is an estimated profit or loss on an investment over a period, based on probabilities or historical data.
• It serves as a crucial input in Portfolio Management and Asset Allocation strategies.
• While a valuable forecasting tool, expected return is not a guaranteed outcome and is subject to various influencing factors.
• It helps investors compare the potential profitability of different investment options and align them with their Risk Management goals¹⁷.
• Expected return is a component in advanced financial models like the Capital Asset Pricing Model (CAPM).

Formula and Calculation

The expected return for an investment can be calculated by weighting each possible return by its probability and summing the results.

For a single investment with multiple possible outcomes:

Where:

• (E(R)) = Expected Return
• (R_i) = Possible return in scenario (i)
• (P_i) = Probability of return (R_i) occurring
• (n) = Number of possible scenarios

For a portfolio consisting of multiple assets, the expected return of the portfolio is the weighted average of the expected returns of the individual assets within it.

Where:

• (E(R_p)) = Expected return of the portfolio
• (w_j) = Weight (proportion) of asset (j) in the portfolio
• (E(R_j)) = Expected return of individual asset (j)
• (m) = Number of assets in the portfolio

Another common approach to estimate expected return, particularly for individual securities, involves the Capital Asset Pricing Model (CAPM), which integrates the Risk-Free Rate, the asset's Beta, and the Market Risk Premium¹⁶.

Interpreting the Expected Return

Interpreting expected return involves understanding it as a probabilistic estimate rather than a definitive forecast. A higher expected return generally implies a greater potential for profit, but it often comes with a higher degree of Volatility or risk. Investors use expected return as a benchmark to compare different investment opportunities, helping them decide where to allocate capital based on their individual risk tolerance and financial goals¹⁵.

For example, an asset with a 10% expected return suggests that, on average, for every dollar invested, one could anticipate a return of 10 cents over the specified period, given the underlying probabilities. However, this average does not mean that the investment will actually yield 10%; it could perform better or worse depending on actual Market Conditions and unforeseen events. Consequently, expected return is used in conjunction with risk measures, such as standard deviation, to provide a more comprehensive view of an investment's profile¹⁴.

Hypothetical Example

Consider an investor evaluating two potential investments: Company A stock and a bond fund.

Company A Stock:

• Scenario 1 (Strong Economy): 20% return with a 30% probability
• Scenario 2 (Normal Economy): 10% return with a 50% probability
• Scenario 3 (Weak Economy): -5% return with a 20% probability

The expected return for Company A stock would be:
(E(R_A) = (0.20 \times 0.30) + (0.10 \times 0.50) + (-0.05 \times 0.20))
(E(R_A) = 0.06 + 0.05 - 0.01)
(E(R_A) = 0.10) or 10%

Bond Fund:

• Scenario 1 (Strong Economy): 4% return with a 30% probability
• Scenario 2 (Normal Economy): 5% return with a 50% probability
• Scenario 3 (Weak Economy): 6% return with a 20% probability

The expected return for the Bond Fund would be:
(E(R_B) = (0.04 \times 0.30) + (0.05 \times 0.50) + (0.06 \times 0.20))
(E(R_B) = 0.012 + 0.025 + 0.012)
(E(R_B) = 0.049) or 4.9%

Based solely on expected return, the investor might initially favor Company A stock (10% vs. 4.9%). However, a prudent investor would also consider the greater Volatility and potential for loss associated with Company A stock compared to the more stable bond fund, emphasizing the need for comprehensive Investment Decisions.

Practical Applications

Expected return is a cornerstone metric used across various facets of finance. In Asset Allocation, it guides investors in distributing their capital among different asset classes like stocks, bonds, and real estate, aiming to create a portfolio that aligns with their desired risk-return profile. Portfolio Managers routinely employ expected return estimates to construct and optimize investment portfolios, often seeking to maximize expected returns for a given level of risk or minimize risk for a target expected return¹², ¹³. Financial institutions and investment firms publish their long-term expected returns for major asset classes, which serve as crucial inputs for strategic planning and client advice¹⁰, ¹¹. This involves analyzing complex macroeconomic scenarios and market valuations to project future performance.

Furthermore, expected return is integral to modern financial models, including the Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory (MPT). These frameworks use expected return, along with measures of risk and correlation, to help investors make informed choices that contribute to long-term wealth accumulation.

Limitations and Criticisms

While indispensable, expected return has notable limitations. A primary critique is that it is a forward-looking estimate based on historical data or assumptions, which may not accurately predict future outcomes. Past performance is not indicative of future results, and unforeseen shifts in Market Conditions can render previous expectations inaccurate⁹.

Another significant limitation arises from the "joint hypothesis problem" associated with the Efficient Market Hypothesis (EMH). This problem states that it is challenging to test whether markets are truly efficient because doing so requires an underlying model of what "rational" expected returns should look like. If empirical tests suggest market inefficiency, it is difficult to determine if the market itself is inefficient or if the assumed model for expected returns is flawed⁸. Behavioral finance also offers criticisms, highlighting that investor psychology and irrational decision-making can lead to deviations from what a purely rational model of expected returns might predict.

Moreover, the accuracy of expected return estimates can be influenced by the quality and availability of input data. For instance, in real-world Financial Forecasting, errors can arise from data inaccuracies, the inherent unpredictability of human behavior, or external shocks that are difficult to quantify⁶, ⁷.

Expected Return vs. Realized Return

Expected return and realized return are distinct but related concepts in finance. Expected return is a hypothetical, forward-looking estimate of the profit or loss an investment is anticipated to generate over a future period. It is a probabilistic measure, calculated by weighing potential outcomes by their likelihoods.

In contrast, realized return (also known as actual return) is the actual gain or loss an investment has generated over a specific past period. It is a historical measure, reflecting the actual performance of an asset or portfolio.

The key difference lies in their temporal orientation and certainty: expected return deals with probabilities and future possibilities, while realized return deals with observed facts from the past. While investors use expected return for Investment Decisions and planning, they evaluate their success by comparing their portfolio's Realized Return against their initial expectations. Discrepancies between the two are common due to market Volatility, unforeseen Economic Indicators, and other factors that affect actual outcomes.

FAQs

Q1: Is expected return a guarantee of future performance?

No, expected return is not a guarantee. It is a statistical estimate based on historical data or assumptions about future probabilities. Actual returns can differ significantly due to unpredictable Market Conditions and other factors⁵.

Q2: How is expected return used in investment planning?

In investment planning, expected return helps investors set realistic goals, evaluate different investment opportunities, and construct a diversified portfolio. It’s a key input for Asset Allocation models that aim to balance potential returns with associated risks.
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Q3: What factors influence an investment's expected return?

Several factors influence expected return, including prevailing Market Conditions, Economic Indicators like interest rates and inflation, the specific asset class (e.g., stocks vs. bonds), the investment horizon, and the inherent Risk Management profile of the investment.
³

Q4: Can expected return be negative?

Yes, expected return can be negative. A negative expected return indicates that, on average, the investment is anticipated to result in a loss over the specified period, based on the probabilities of various negative outcomes.

Q5: How does expected return relate to risk?

Expected return and risk are often directly related: higher expected returns typically come with higher levels of risk or Volatility. Investors generally seek a balance between the two, using frameworks like Modern Portfolio Theory (MPT) to optimize their portfolios for a desired risk-return tradeoff.¹, ²