Expected Return

Definition

Expected return is the anticipated profit or loss from an investment over a specific period, calculated as a weighted average of all possible returns, each multiplied by its probability of occurrence. This concept helps investors gauge the potential profitability of various investments, allowing for better decision-making regarding asset allocation and risk management.

5 Must Know Facts For Your Next Test

1. Expected return is commonly calculated using historical data to estimate future performance, providing a basis for making investment decisions.
2. In portfolio theory, expected return is crucial for constructing efficient portfolios that maximize returns while minimizing risk.
3. Different models, such as CAPM, use expected return to assess the relationship between systematic risk and anticipated investment returns.
4. The concept of expected return also underpins the efficient frontier, where investors can identify optimal portfolios based on their risk tolerance and return expectations.
5. Market anomalies can affect expected returns, leading to discrepancies between anticipated and actual investment performance.

Review Questions

• How does expected return relate to portfolio diversification and risk management?
  • Expected return is central to portfolio diversification as it helps investors understand how combining different assets can influence overall returns. By considering the expected returns of various investments, one can construct a diversified portfolio that balances higher-return assets with those of lower volatility. This strategic mix aims to optimize potential returns while mitigating risk, as different assets may respond differently to market conditions.
• In what ways do models like CAPM utilize expected return to inform investment decisions?
  • The Capital Asset Pricing Model (CAPM) leverages expected return by linking it directly to the systematic risk of an asset, represented by its beta. The model calculates an asset's expected return based on its risk in relation to the overall market, providing a benchmark for investors. This relationship allows investors to determine whether an asset offers a favorable return given its risk profile compared to other investment opportunities.
• Evaluate how market anomalies can impact the reliability of expected return as a predictive measure for future performance.
  • Market anomalies can significantly distort the reliability of expected return as a predictor of future performance. Factors such as behavioral biases, mispricing, and unexpected events can lead to actual returns that diverge from those anticipated by historical data and models. Consequently, while expected return serves as a useful tool for assessing investment opportunities, it should be employed with caution and supplemented by a broader analysis that accounts for market inefficiencies and changing conditions.

Related terms

Risk-Return Tradeoff: The balance between the potential risk an investor takes and the expected return from an investment; typically, higher returns come with higher risks.

Variance: A statistical measure of the dispersion of returns around the mean; it helps assess the risk associated with an investment's expected return.

Discount Rate: The interest rate used to determine the present value of future cash flows; it impacts the calculation of expected returns by adjusting for time value.