Expected return

By Mensholong Lepcha and Paul SoreneEdited by Alexandra Pankratyeva11:16 (UTC), 8 April 2022

Expected return is the amount of profit or loss anticipated from an investment.

Find out what expected return means. And learn how to calculate expected return. In this article, we will also come across examples on how to use expected return.

Expected return predicts the return on an investment based on the historical rates of return. According to the expected return definition, it’s calculated by multiplying the potential outcomes of profit or loss with the probability of these events occurring and then totalling the results.

Expected return calculations are key to practical investment theories like modern portfolio theory and the Black-Scholes model. Modern portfolio theory is a method used to select investments with the aim of maximising overall returns within an acceptable level of risk. The Black-Scholes model is used to calculate option contracts using stock prices, strike price, expected dividends, expected interest rates, expiration date and expected volatility.

Expected return is used to determine the average net outcome of an investment. It’s the sum of the expected value of an investment, taking into account various scenarios and corresponding potential returns.

Expected return formula

The formula for calculating expected return on an investment is as follows:

Expected return formula

To put it simply, let’s take an investment that has a 40% chance of gaining 25% and a 60% chance of losing 10%. The expected return of the investment will be:

Expected return = (40% x 25%) + (60% x (- 10%) ) = 0.1 - 0.06 = 0.04 or 4%

Here, the investment is expected to return a profit of 4%.

A more advanced equation for calculating the expected return from an investment is:

Expected return = risk free premium + Beta x (Expected market return - risk free premium)

Risk free premium is a theoretical zero risk rate of return on an investment. Beta is the measure of market volatility of an investment compared to the market as a whole.

Expected return example

Let’s evaluate an investor’s portfolio using the expected return formula. Let’s say that a portfolio consists of:

$400 invested in Tesla (TSLA), which has an expected return of 40%
$300 invested in Unilever (ULVR), which has an expected return of 5%
$300 invested in Microsoft (MSFT), which has an expected return of 15%

The total invested value of the portfolio is $1,000, where Tesla, Unilever and Microsoft have weightage of 40%, 30% and 40%, respectively.

The expected return of the portfolio will be:

Expected return = (40% x 40%) + (30% x 5%) + (30% x 15%) = 0.16 + 0.015 + 0.045 = 0.22 = 22% return

What is a good expected return? According to SoFi: “A good return on investment is generally considered to be about 7% per year. This is the barometer that investors often use based off the historical average return of the S&P 500 after adjusting for inflation.”

Drawbacks of expected return

Calculating and using expected return methodologies blindly in investing is not advisable. One has to understand that expected returns are calculated on the basis of their historical returns and thus does not guarantee an outcome in the future.

Investments are subject to systematic risks, which is also known as volatility which affects the entire market, and unsystematic risks, which are risks specific to a company or sector.