Expected return

Definition

Expected return is the anticipated profit or loss from an investment, calculated based on the probabilities of different outcomes. It serves as a critical measure in assessing the potential rewards of an investment compared to its risks. By understanding expected return, investors can make informed decisions about where to allocate their resources, taking into account factors like market conditions and the inherent riskiness of the investment, which ties into broader concepts such as risk premiums and market behavior.

5 Must Know Facts For Your Next Test

1. Expected return can be calculated using historical data, market analysis, or financial models to estimate potential outcomes.
2. The Capital Asset Pricing Model (CAPM) connects expected return to systematic risk through the formula: $$E(R_i) = R_f + \beta_i(E(R_m) - R_f)$$.
3. Investors generally seek investments with a higher expected return to justify taking on additional risk.
4. Size premium refers to the added expected return investors require for investing in smaller companies, which are generally considered riskier than larger firms.
5. Expected return plays a key role in portfolio management, helping investors balance their desired risk levels against potential rewards.

Review Questions

• How does the concept of expected return relate to the overall risk and reward trade-off in investments?
  • Expected return is directly linked to the risk-reward trade-off in investments, as it provides a quantifiable measure of what an investor might anticipate earning from an investment relative to its associated risks. Generally, higher risks should correspond to higher expected returns, thus allowing investors to gauge whether potential earnings justify taking on additional risk. Understanding this relationship is vital for making informed investment choices that align with individual risk tolerance levels.
• Analyze how the Capital Asset Pricing Model utilizes expected return in evaluating investment opportunities.
  • The Capital Asset Pricing Model (CAPM) uses expected return as a central component for evaluating investment opportunities by establishing a relationship between an asset's expected return and its systematic risk, measured by beta. The formula demonstrates that the expected return on an asset equals the risk-free rate plus a premium that compensates for its risk relative to the market. This model helps investors make decisions by comparing an asset's expected return against its inherent risks and the returns of alternatives.
• Evaluate the implications of size premium on expected returns for small-cap versus large-cap stocks within the investment landscape.
  • The size premium suggests that investors expect higher returns from small-cap stocks compared to large-cap stocks due to their increased risk and volatility. This higher expected return compensates investors for uncertainties associated with smaller companies, including less market liquidity and greater sensitivity to economic changes. By recognizing this phenomenon, investors can strategically allocate their portfolios to harness potential growth from small-cap investments while balancing risks inherent in such strategies against more stable large-cap stocks.

Related terms

Risk premium: The additional return expected from an investment to compensate for its higher risk compared to a risk-free asset.

Portfolio return: The overall return on a collection of investments, weighted by the proportion of each asset in the portfolio.

Beta:

A measure of a stock's volatility in relation to the overall market, used to assess its risk and expected return.