Expected return",

What Is Expected Return?

Expected return is the anticipated profit or loss on an investment over a specified period. It represents the average outcome of all possible returns, weighted by their respective probabilities, and is a foundational concept in investment analysis and portfolio theory. Investors and financial analysts use expected return to make informed decisions about potential investments, balancing the potential for gain against associated risks. This metric is a key component in assessing an asset's attractiveness and forms the basis for various financial models.

History and Origin

The concept of expected return gained prominence with the development of Modern Portfolio Theory (MPT), pioneered by economist Harry Markowitz. Markowitz introduced his seminal work on portfolio selection in a 1952 essay and later expanded on it in his 1959 book, Portfolio Selection: Efficient Diversification. His theory provided a framework for optimizing investment portfolios based on the expected returns of assets and their covariances (how they move together), aiming to achieve the maximum possible expected return for a given level of risk⁹. Markowitz's work, which earned him a Nobel Memorial Prize in Economic Sciences in 1990, laid the groundwork for quantitative finance by emphasizing the importance of diversification and the trade-off between risk and expected return⁸.

Key Takeaways

Expected return is the probable average return an investment may yield over time.
It is a forward-looking estimate, based on historical data, current market conditions, and future expectations.
Expected return is crucial for evaluating potential investments and for constructing diversified portfolios.
It is often paired with a measure of risk, such as standard deviation, to assess risk-adjusted return.
Expected return differs from realized return, which is the actual return achieved.

Formula and Calculation

The expected return on a single asset is calculated as the sum of the products of each possible return scenario and its probability:

E(R) = \sum_{i=1}^{n} (R_i \times P_i)

Where:

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

For a portfolio, the expected return is the weighted average of the expected returns of its individual assets:

E(R_p) = \sum_{j=1}^{m} (w_j \times E(R_j))

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 asset (j)
(m) = Number of assets in the portfolio

This formula underscores how asset allocation influences the overall expected return of an investment portfolio.

Interpreting the Expected Return

Expected return provides an estimate of what an investor might anticipate earning from an investment. A higher expected return generally implies a higher potential reward, but it also typically comes with a higher degree of market risk. When interpreting expected return, it is critical to consider the underlying assumptions used in its calculation, especially the assigned probabilities to different scenarios. For instance, an investment with a 10% expected return based on optimistic assumptions might be less appealing than one with an 8% expected return based on more conservative, realistic scenarios. Investors often compare the expected return of various assets against their risk tolerance to make suitable investment choices.

Hypothetical Example

Consider an investment in a new technology stock. An analyst identifies three possible future scenarios for the stock's performance over the next year:

Best Case: The company releases a breakthrough product, and the stock sees a 25% return. The probability of this occurring is estimated at 30%.
Normal Case: The company performs as expected, and the stock yields a 10% return. The probability is 50%.
Worst Case: A competitor launches a superior product, and the stock falls by 15%. The probability is 20%.

Using the expected return formula:

(E(R) = (0.25 \times 0.30) + (0.10 \times 0.50) + (-0.15 \times 0.20))
(E(R) = 0.075 + 0.050 - 0.030)
(E(R) = 0.095)

In this hypothetical example, the expected return for the technology stock is 9.5%. This figure can then be used in further portfolio diversification strategies or for comparing against other investment opportunities.

Practical Applications

Expected return is widely applied across various facets of finance:

Investment Decisions: Investors use expected return alongside risk measures to select individual securities or entire portfolios that align with their financial goals. It helps quantify the potential reward from an investment.
Portfolio Construction: Financial advisors and portfolio managers leverage expected return estimates to build portfolios, aiming to optimize the balance between return and risk. This is a core tenet of modern portfolio management.
Valuation Models: Expected return is often incorporated into valuation methodologies, such as the discounted cash flow (DCF) model, where future cash flows are discounted to their present value using a discount rate that reflects the expected return.
Economic Forecasting: Large institutions like the International Monetary Fund (IMF) regularly publish expected return or growth rates for various economies, which inform global investment and policy decisions. For instance, the IMF's July 2025 World Economic Outlook Update projects global growth rates, providing a macro-level expected return for the global economy⁵, ⁶, ⁷. These forecasts often rely on various economic indicators.

Limitations and Criticisms

While a crucial concept, expected return has notable limitations:

Forward-Looking Uncertainty: Expected return is a projection, not a guarantee. It relies on assumptions about future events and probabilities, which are inherently uncertain. Unforeseen circumstances, such as geopolitical events or sudden economic shifts, can significantly impact actual outcomes.
Reliance on Historical Data: Often, probabilities and past returns are derived from historical data. However, "past performance is not indicative of future results" is a standard disclaimer because market conditions change, and historical trends may not repeat.
Subjectivity: Assigning probabilities to various scenarios can be subjective and vary significantly between analysts, leading to different expected return calculations for the same asset.
Ignoring Tail Risks: The expected return calculation might not adequately capture the impact of extreme, low-probability events (tail risks) that could lead to significant losses.
Forecasting Challenges: Economic and market forecasting, upon which expected return estimates often depend, is notoriously difficult. Economists often struggle to predict recessions, highlighting the challenges in accurately projecting future economic conditions that influence returns³, ⁴. Such forecasts can be prone to over-precision and can sometimes be significantly off the mark². The UN Office for Disaster Risk Reduction (UNDRR) emphasizes that understanding and managing risk is complex, especially as interconnected systems and changing global dynamics challenge traditional models that rely on past data¹.

Expected Return vs. Realized Return

Expected return and realized return are two distinct but related concepts in finance.

Feature	Expected Return	Realized Return
Definition	Anticipated or projected return	Actual return achieved over a period
Nature	Forward-looking estimate, theoretical	Backward-looking, factual
Calculation	Based on probabilities of future scenarios	Based on historical prices and income received
Purpose	Investment decision-making, portfolio planning	Performance evaluation, historical analysis
Certainty	Uncertain, subject to assumptions and forecasts	Certain (once the period is complete)

The primary confusion between the two often arises when investors assume their expected return will perfectly match their realized return. In reality, due to market volatility and unforeseen events, the realized return rarely aligns precisely with the initial expected return. Expected return is a planning tool, while realized return is a measure of performance.

FAQs

How often should I recalculate expected return for my investments?

Recalculating expected return depends on the investment and market volatility. For long-term investments, an annual review might suffice. For more volatile assets or during periods of significant market changes or new economic indicators, more frequent reassessments (e.g., quarterly or monthly) might be appropriate to keep your investment analysis current.

Can expected return be negative?

Yes, expected return can be negative. A negative expected return indicates that, based on the probabilities and potential outcomes, the investment is anticipated to lose money over the specified period. This might occur during periods of economic contraction or for assets with high risk and low potential for positive returns.

What is the difference between expected return and required return?

Expected return is what an investor anticipates earning from an investment. Required return is the minimum rate of return an investor demands or needs to compensate them for the risk taken, given alternative investment opportunities. If the expected return of an asset is less than its required return, an investor would typically not consider it a viable investment.

Does expected return account for inflation?

The basic calculation of expected return often does not explicitly account for inflation. The returns used in the formula are typically nominal returns. To get a real expected return (after accounting for purchasing power), you would need to adjust the nominal expected return for the expected inflation rate over the investment horizon, similar to how future value is adjusted for inflation.

Is a higher expected return always better?

Not necessarily. A higher expected return usually comes with a higher level of risk. Investors must consider their individual risk tolerance and financial goals. An investment with a very high expected return but also extremely high risk might not be suitable for a conservative investor seeking stable growth. The goal is often to find the optimal balance that provides the best risk-adjusted expected return.