Expected Return

Definition

Expected return is the anticipated return on an investment, calculated as the weighted average of all possible outcomes, each multiplied by its probability of occurrence. This concept helps investors make informed decisions by assessing potential profitability and risk associated with various assets, and is foundational in understanding how different investments can contribute to an overall portfolio's performance.

5 Must Know Facts For Your Next Test

1. Expected return is crucial for determining the optimal asset allocation in a portfolio, guiding investors in their choices based on anticipated performance.
2. The expected return can be calculated using historical data or projected future performance, depending on investor preference and available information.
3. In Modern Portfolio Theory, expected return is balanced with risk, where higher expected returns generally come with greater risk.
4. The Capital Asset Pricing Model (CAPM) uses expected return to estimate the relationship between systematic risk and expected asset returns, emphasizing the concept of beta.
5. Investors often compare the expected return of various assets against benchmarks or risk-free rates to evaluate potential investment opportunities.

Review Questions

• How does the concept of expected return influence the construction of an investment portfolio?
  • Expected return plays a vital role in portfolio construction by helping investors determine which assets to include based on their anticipated performance. By calculating the expected return for different investments, individuals can assess how each option aligns with their financial goals and risk tolerance. This allows for a more informed allocation of resources, aiming for a balance between maximizing returns and minimizing risks.
• Discuss the relationship between expected return and risk as presented in Modern Portfolio Theory.
  • In Modern Portfolio Theory, there is a direct relationship between expected return and risk; typically, higher returns are associated with higher levels of risk. Investors must understand this trade-off when building their portfolios. The theory suggests that by diversifying investments across various assets, individuals can optimize their expected returns while managing risk more effectively, resulting in a more efficient portfolio that aligns with their risk appetite.
• Evaluate how the Capital Asset Pricing Model (CAPM) integrates expected return with market risk and individual asset performance.
  • The Capital Asset Pricing Model (CAPM) integrates expected return by linking it directly to market risk through the beta coefficient, which measures an asset's volatility relative to the overall market. CAPM provides a formula to calculate expected return based on risk-free rate, the asset's beta, and the expected market return. By doing so, it helps investors understand how much additional return they should expect for taking on systematic risk compared to a completely risk-free investment, enabling better decision-making in asset selection.

Related terms

Risk Premium: The additional return an investor expects to receive for taking on additional risk compared to a risk-free investment.

Diversification: The practice of spreading investments across various assets to reduce risk and improve potential returns.

Variance: A statistical measurement of the dispersion of returns for a given security or market index, indicating the level of risk associated with the investment.