Expected Return

Definition

Expected return is the anticipated average return on an investment over a specified period, taking into account the probability of different outcomes. It helps investors evaluate the potential profitability of an investment by weighing the possible returns against their likelihood, guiding decisions in portfolio construction and asset allocation.

5 Must Know Facts For Your Next Test

1. Expected return is often calculated as the weighted average of possible returns, with weights based on their probabilities.
2. In portfolio optimization, higher expected returns are usually associated with higher levels of risk, making it essential to consider both when making investment decisions.
3. Investors often use historical data to estimate expected returns, but future performance can be influenced by market conditions and economic factors.
4. The expected return is crucial for determining the optimal asset allocation within a portfolio, helping investors achieve desired risk levels while maximizing potential gains.
5. Understanding expected return helps investors avoid underestimating or overestimating potential profits, which can lead to poor investment choices.

Review Questions

• How does the concept of expected return influence decision-making in portfolio optimization?
  • Expected return plays a critical role in portfolio optimization as it helps investors assess which assets might provide the best potential gains for a given level of risk. By estimating the average return an investment could yield, investors can compare different assets and determine how to allocate resources effectively. This assessment allows for constructing portfolios that align with individual risk tolerance while aiming for desired returns.
• Discuss how expected return is calculated and its implications for risk management in investment portfolios.
  • Expected return is calculated by taking the weighted average of all possible returns, with weights assigned according to their probabilities. This calculation has significant implications for risk management as it allows investors to gauge potential performance against associated risks. By understanding both expected return and variance, investors can make informed decisions about how much risk to take on when constructing their portfolios.
• Evaluate how changes in market conditions might affect the expected return on a diversified investment portfolio and what strategies can be employed to mitigate risks associated with such changes.
  • Changes in market conditions can significantly affect the expected return on a diversified investment portfolio, as economic factors like interest rates, inflation, and geopolitical events can alter asset performance. To mitigate risks related to these changes, investors can employ strategies such as rebalancing their portfolios, utilizing options for hedging purposes, or incorporating assets with different correlations to reduce overall volatility. By staying adaptable and responsive to market shifts, investors can better protect their portfolios while striving to maintain favorable expected returns.

Related terms

Variance: A measure of the dispersion of returns around the expected return, indicating the risk associated with an investment.

Risk-Return Tradeoff: The principle that potential return rises with an increase in risk, emphasizing the balance investors must strike when building a portfolio.

Capital Asset Pricing Model (CAPM): A model that establishes a relationship between the expected return of an asset and its systematic risk, providing a way to calculate expected returns based on risk.