Calculate the Expected Return of an Investment

By Stock Research Pro • May 10th, 2009

The Expected Return of an investment is the average of a probability distribution of possible returns for that investment. Although investors do not know with certainty what rate of return their investments will yield, they can base their decisions on their expectations by assigning a level of probability to a number of possible outcomes. Calculating an expected return then becomes a matter of taking the probability of each possible return, multiplying it by the return itself, and adding those values.


What is Probability Theory?

As we know, probability is simply the likelihood that something will happen. Probability theory is the mathematical foundation for statistics, used to provide insight into outcomes that depend on chance or uncertainty. For investors, probability theory is applied to quantify a likely outcome for an investment opportunity.


What is Weighted Average?

In calculating an expected return for an investment, a weighted average is used to assign relative importance to each of the potential outcomes. The more likely scenarios carry more weight in arriving at an expected return.


Note: To complete the calculation, probability total should equal 100%


Using the Calculator- An Expected Return Example

To illustrate the use of probability and weighted average to arrive at an expected return for an investment, let’s say that a given investment opportunity has a 50% probability of a 10% return; a 20% probability of a 12% return; a 15% probability of a 6% return; and a 15% probability of a 15% return. In this case, the formula for the expected return can be written as:


Expected Return = (.50)(.10) + (.20)(.12) + (.15)(.06) + (.15)(.15) = 10.4%

In this case, the expected return of the investment would be 10.4%. Please note that, to complete the calculation, the sum of the probabilities should equal 100%.


Expected Return v. Abnormal Return

Abnormal return is a term used to describe a scenario where the returns generated by a given investment or portfolio are different from the expected return. Abnormal returns can be either good or bad as the investment(s) might outperform or underperform in generating abnormal returns.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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