Expected return

Definition

Expected return is the anticipated profit or loss an investor can expect from an investment over a specified period, calculated as a weighted average of all possible returns, each multiplied by the probability of its occurrence. This concept is crucial for assessing the potential performance of an investment and helps investors make informed decisions based on their risk tolerance and investment goals.

5 Must Know Facts For Your Next Test

1. Expected return is often represented as a percentage and incorporates both potential gains and losses from an investment.
2. It is calculated using historical data or forecasts, making it crucial for decision-making in investment strategies.
3. Investors use expected return to evaluate the attractiveness of various investments compared to their inherent risks.
4. A higher expected return typically comes with increased risk, aligning with the risk-return tradeoff principle in finance.
5. Calculating expected return accurately can involve complex modeling, especially in real estate, where factors like location and market trends play significant roles.

Review Questions

• How can understanding expected return help investors manage their portfolios more effectively?
  • Understanding expected return allows investors to assess the potential profitability of different investments in their portfolios. By analyzing the anticipated returns alongside the associated risks, investors can make informed decisions about which assets to include or exclude. This knowledge aids in balancing the portfolio to align with their risk tolerance and financial objectives, ultimately leading to better long-term performance.
• Discuss how the Capital Asset Pricing Model (CAPM) relates to expected return and its implications for investment strategy.
  • The Capital Asset Pricing Model (CAPM) directly ties expected return to systematic risk through the equation: $$E(R) = R_f + \beta(E(R_m) - R_f)$$, where $$E(R)$$ is the expected return, $$R_f$$ is the risk-free rate, $$\beta$$ measures volatility relative to the market, and $$E(R_m)$$ represents the expected market return. By utilizing CAPM, investors can determine if an asset's expected return compensates adequately for its risk. This understanding helps shape investment strategies that optimize returns relative to the risks taken.
• Evaluate how portfolio diversification impacts the expected return of an investment strategy and its overall risk.
  • Portfolio diversification is crucial in managing both expected return and risk. By spreading investments across different assets, sectors, or geographic regions, an investor can mitigate unsystematic risk that affects individual assets while still aiming for a competitive overall expected return. This strategy helps stabilize returns during market fluctuations, allowing investors to achieve their financial goals with less volatility. Ultimately, diversification strikes a balance between enhancing potential returns and reducing exposure to significant losses.

Related terms

Risk Premium: The additional return an investor expects to earn from holding a risky asset compared to a risk-free asset.

Portfolio Diversification: The strategy of spreading investments across various assets to reduce overall risk while aiming for an optimal expected return.

Capital Asset Pricing Model (CAPM): A model that establishes a relationship between the expected return of an asset and its systematic risk, often used to determine a theoretically appropriate required rate of return.