Expected return

Definition

Expected return is the anticipated return on an investment based on its probable outcomes, weighted by their respective probabilities. It provides a way to measure the potential profitability of an investment, incorporating both the risk and reward associated with it. Understanding expected return is crucial when analyzing various investment opportunities and constructing a balanced portfolio.

5 Must Know Facts For Your Next Test

1. Expected return is calculated as the sum of all possible returns, each multiplied by its probability of occurrence.
2. In finance, expected return is often used to evaluate and compare different investment options, guiding investors towards more informed decisions.
3. The formula for expected return can include various factors like historical performance, market trends, and economic indicators.
4. Investors use expected return alongside measures like standard deviation and beta to gauge the risk associated with different investments.
5. An investment with a higher expected return typically comes with greater risk, which is why understanding this concept is essential for effective portfolio management.

Review Questions

• How does expected return influence an investor's decision-making process when evaluating investment opportunities?
  • Expected return plays a key role in helping investors assess the potential profitability of various investments. By calculating the expected return, investors can compare different opportunities and determine which ones align best with their risk tolerance and financial goals. This analysis allows them to make more informed decisions, focusing on investments that offer favorable risk-return profiles.
• Discuss how expected return is integrated into the Capital Asset Pricing Model (CAPM) and its significance in determining the appropriate required return on an asset.
  • In the Capital Asset Pricing Model (CAPM), expected return is derived from the risk-free rate plus a premium that compensates for systematic risk as measured by beta. This relationship illustrates how much additional return investors require for taking on extra risk compared to a risk-free investment. CAPM emphasizes that the expected return on an asset should reflect its inherent risks, guiding investors in pricing assets appropriately.
• Evaluate the implications of using expected return in Modern Portfolio Theory for constructing an optimal investment portfolio.
  • Using expected return in Modern Portfolio Theory allows investors to construct portfolios that maximize returns while minimizing risk through diversification. The theory suggests that by combining assets with different expected returns and correlations, investors can achieve a more favorable overall portfolio performance. This approach not only highlights the importance of expected return in achieving optimal asset allocation but also underscores how balancing high and low-risk investments can lead to better long-term outcomes.

Related terms

Risk-Return Tradeoff: The principle that potential return rises with an increase in risk, indicating that higher levels of risk are generally associated with higher potential returns.

Variance: A statistical measurement that indicates the dispersion of returns for a given security or market index, helping to assess the level of risk associated with an investment.

Beta: A measure of a stock's volatility in relation to the overall market, indicating how much the expected return of an asset changes when the market moves.