Expected returns: Meaning, Criticisms & Real-World Uses

What Is Expected Returns?

Expected returns represent the anticipated profit or loss an investor might realize on an investment, often over a specific period. It is a core concept in Investment Analysis and portfolio management, providing a forward-looking estimate rather than a historical fact. Investors and analysts utilize expected returns to make informed decisions about asset allocation and to gauge the potential profitability of various securities or portfolios. Understanding expected returns is crucial for aligning investment choices with an individual's risk tolerance and financial objectives, forming a foundational component of portfolio diversification.

History and Origin

The systematic concept of expected returns, particularly in the context of diversified portfolios, gained prominence with the advent of Modern Portfolio Theory (MPT). Pioneered by Harry Markowitz in his seminal 1952 paper, "Portfolio Selection," MPT provided a mathematical framework for constructing investment portfolios based on the interplay of risk and return. Markowitz's work revolutionized finance by demonstrating how investors could optimize their portfolios by considering the expected returns of individual assets alongside their covariance, rather than simply focusing on individual security performance. This groundbreaking research, which earned Markowitz a Nobel Memorial Prize in Economic Sciences in 1990, laid the foundation for how expected returns are understood and applied in modern financial markets.⁴

Key Takeaways

Expected returns are a probabilistic estimate of an investment's future performance, not a guarantee.
They are a fundamental input for portfolio construction and financial modeling.
Expected returns are influenced by various factors, including historical data, economic forecasts, and the specific characteristics of the asset.
Different methods exist for calculating expected returns, ranging from simple averages to more complex models like the Capital Asset Pricing Model (CAPM).
While indispensable for planning, the actual realized returns may differ significantly from expected returns due to unforeseen market events or economic shifts.

Formula and Calculation

The calculation of expected returns can vary depending on the asset and the complexity desired. For a single asset, a common approach involves weighting the potential outcomes by their respective probability of occurrence.

For a portfolio of assets, the expected return is the weighted average of the expected returns of each asset within the portfolio:

$E(R_p) = \sum_{i=1}^{n} (w_i \cdot E(R_i))$

Where:

(E(R_p)) = Expected return of the portfolio
(w_i) = Weight (proportion) of asset (i) in the portfolio
(E(R_i)) = Expected return of individual asset (i)
(n) = Total number of assets in the portfolio

Another widely used model, particularly for equity investments, is the Capital Asset Pricing Model (CAPM), which estimates the expected return of an asset:

$E(R_i) = R_f + \beta_i (E(R_m) - R_f)$

Where:

(E(R_i)) = Expected return of asset (i)
(R_f) = Risk-free rate (e.g., return on a U.S. Treasury bond)
(\beta_i) = Beta of asset (i), a measure of its systematic risk
(E(R_m)) = Expected return of the overall market

Interpreting Expected Returns

Interpreting expected returns requires context and an understanding of the assumptions underpinning the calculation. A higher expected return generally implies a higher level of market risk, consistent with the risk-reward principle in finance. Investors use expected returns to compare potential investments and to determine if the anticipated compensation justifies the inherent risk. For instance, an investment with a 10% expected return might be attractive if its associated risk is low, but less so if it carries substantial risk when compared to alternatives offering similar potential but lower volatility. Ultimately, expected returns serve as a critical input for investment decisions, guiding choices that align with an investor's investment horizon and financial goals.

Hypothetical Example

Consider an investor evaluating a potential investment in a new technology startup. Based on market research and expert opinions, they identify three possible scenarios for the startup's annual performance:

Scenario 1 (Optimistic): A 30% return with a 25% probability.
Scenario 2 (Moderate): A 10% return with a 50% probability.
Scenario 3 (Pessimistic): A -5% return (loss) with a 25% probability.

To calculate the expected return for this investment, the investor would multiply the return of each scenario by its probability and sum the results:

Expected Return = (0.25 * 30%) + (0.50 * 10%) + (0.25 * -5%)
Expected Return = 7.5% + 5% - 1.25%
Expected Return = 11.25%

This 11.25% expected return helps the investor assess the potential profitability of this startup compared to other opportunities, aiding their overall investment decision-making and valuation process.

Practical Applications

Expected returns are integral to various aspects of finance and investing:

Portfolio Management: Fund managers and individual investors use expected returns to construct portfolios that aim to maximize returns for a given level of risk or minimize risk for a target return. This is a core tenet of Modern Portfolio Theory.
Capital Budgeting: Businesses estimate the expected returns of various projects or investments to decide where to allocate capital, often using discounted cash flow analysis which relies on future expected cash flows and a discount rate.
Security Analysis: Analysts forecast future capital gains and dividend yield to arrive at an expected return for individual stocks or bonds, which then feeds into their buy/sell recommendations.
Economic Forecasting: Central banks and government agencies publish economic projections, which implicitly or explicitly contain expected returns for various asset classes or overall economic growth, influencing market expectations. For example, the Federal Reserve provides its Summary of Economic Projections (SEP) several times a year, outlining expectations for GDP growth, inflation, and unemployment.³
Performance Benchmarking: Expected returns provide a baseline against which actual investment performance can be measured. Market analysts regularly publish their expectations for corporate earnings and revenue, and companies' actual results are then compared against these forecasts, often leading to significant market reactions if expectations are notably beaten or missed.²

Limitations and Criticisms

While essential, expected returns come with inherent limitations:

Forward-Looking Uncertainty: Expected returns are, by definition, estimates of the future, which is inherently uncertain. They rely on assumptions about economic conditions, market behavior, and company performance, which may not materialize as predicted. Unexpected events, often called "black swan" events, can drastically alter actual returns.
Reliance on Historical Data: Many models for calculating expected returns heavily depend on historical performance data. However, "past performance is not indicative of future results" is a standard disclaimer because market conditions and economic landscapes constantly evolve, potentially rendering historical trends less relevant.
Behavioral Biases: Investor psychology can influence expected returns. Optimism or pessimism can lead to inflated or deflated expectations, respectively. For instance, during market bubbles, investors might project unsustainably high expected returns, while during downturns, they might underestimate long-term potential.
Model Dependence: The accuracy of expected returns is highly dependent on the model used for their calculation. Different models can produce significantly different expected returns for the same asset, and each model has its own set of assumptions and limitations. Economic Letters from institutions like the Federal Reserve Bank of San Francisco frequently explore how various factors and models influence economic and market outlooks, highlighting the complexities and potential pitfalls in forecasting.¹

Expected Returns vs. Realized Returns

The terms "expected returns" and "realized returns" are often confused but represent distinct concepts in finance.

Expected Returns are forward-looking estimates of an investment's future performance. They are theoretical calculations based on various assumptions, models, and probabilities. Investors use expected returns for planning, decision-making, and setting performance benchmarks. They represent what an investor hopes or predicts to earn from an investment over a certain period.

Realized Returns (or "actual returns") are backward-looking measurements of an investment's historical performance. They represent the actual profit or loss generated by an investment over a specific period. Realized returns are calculated after the investment period has concluded, taking into account all capital gains, dividends, interest, or losses.

The key difference lies in their temporal nature: expected returns are predictions for the future, while realized returns are facts about the past. While investors use expected returns to guide their decisions, the actual outcome is always the realized return. Significant discrepancies between the two are common and can stem from unforeseen market volatility, economic shifts, or errors in initial assumptions.

FAQs

Q1: Are expected returns guaranteed?

No, expected returns are not guaranteed. They are estimates or forecasts based on available information and assumptions about future conditions. Actual future value of an investment can differ significantly from its expected return due to market fluctuations, economic changes, or unforeseen events.

Q2: How are expected returns used in portfolio construction?

In portfolio construction, expected returns help investors and fund managers choose assets that, when combined, offer the best potential for achieving investment goals given a certain level of risk tolerance. They are crucial inputs in quantitative models that aim to optimize the risk-return trade-off of a [portfolio diversification].

Q3: What factors influence expected returns?

Expected returns are influenced by a multitude of factors, including macroeconomic conditions (e.g., GDP growth, inflation), interest rates, industry trends, company-specific performance, and prevailing market sentiment. Historical performance data and [financial modeling] are often used as a basis for these estimates.