Expected Return

Definition

The expected return is the anticipated or average return an investor expects to receive on an investment or asset over a given period of time. It is a crucial concept in the context of understanding risk and return, as well as the application of the Capital Asset Pricing Model (CAPM) to evaluate the performance of investments.

5 Must Know Facts For Your Next Test

1. The expected return is the average or anticipated return an investor expects to receive on an investment or asset over a given period of time.
2. The expected return is influenced by the risk associated with the investment, with higher-risk assets typically having a higher expected return to compensate for the increased risk.
3. The expected return is a crucial input in the Capital Asset Pricing Model (CAPM), which is used to determine the required rate of return for an asset based on its risk.
4. The expected return can be calculated using historical data or by forecasting future returns based on market conditions and other factors.
5. Understanding the expected return is essential for making informed investment decisions and evaluating the performance of investment portfolios.

Review Questions

• Explain how the expected return is related to the risk of an individual asset.
  • The expected return of an individual asset is directly related to the risk associated with that asset. Generally, assets with higher risk, as measured by factors like volatility or beta, will have a higher expected return to compensate investors for taking on the additional risk. Investors typically require a higher expected return for riskier assets to offset the potential for greater losses. Understanding this relationship between risk and expected return is crucial for making informed investment decisions and constructing well-diversified portfolios.
• Describe the role of the expected return in the Capital Asset Pricing Model (CAPM).
  • The expected return is a key input in the Capital Asset Pricing Model (CAPM), which is used to determine the required rate of return for an asset based on its risk. The CAPM states that the expected return of an asset is equal to the risk-free rate plus a risk premium that is proportional to the asset's beta, or systematic risk. The expected return calculated using the CAPM represents the minimum return an investor would require to hold the asset, given its level of risk. Accurately estimating the expected return is essential for using the CAPM to evaluate the performance of investments and make informed portfolio allocation decisions.
• Analyze how an investor's investment objectives and risk tolerance might influence their expectations for the return on an asset.
  • An investor's investment objectives and risk tolerance are crucial factors that influence their expectations for the return on an asset. Investors with a higher risk tolerance may be willing to accept more volatile assets with the potential for higher returns, while more risk-averse investors may prioritize stability and lower expected returns. Similarly, investors with shorter-term investment horizons may have different return expectations than those with longer-term goals. An investor's age, investment experience, and financial situation can also shape their expectations for the expected return on an asset. Understanding how these individual factors affect return expectations is essential for aligning investment strategies with an investor's unique needs and risk profile.

Related terms

Risk: The possibility of an investment incurring a loss or not achieving the anticipated return. Risk is a key factor in determining the expected return of an asset.

Return: The gain or loss on an investment, typically expressed as a percentage of the initial investment amount. The expected return is the anticipated or average return an investor expects to receive.

Capital Asset Pricing Model (CAPM): A model that describes the relationship between the expected return of an asset and its risk, as measured by the asset's beta. The CAPM is used to determine the required rate of return for an asset.