Expected Return Formula: Meaning, Calculation, Example And Uses

Key Takeaways 
 

• Investors and portfolio managers use various tools to see the risk in investment. Expected return formula is one of them. It gives an average return on investment.
   
• In the expected return formula, possibilities of return are used. First, the probability of return is found out and then it is multiplied with each other. 
   
• Portfolio managers use expected return formulas to compare different return opportunities. And they make the best decision accordingly.

From the word “expected” you can understand the term of expected return. It is simply a profit or loss that investors get in the future. It is an expected return, and based on past results of your investment. You can say that the expected return formula is the average of your past interest return. This formula is used in various financial theories. After getting expected return, investors or company can determine, will this investment give positive or negative income in future. 

Probability expected return 

This formula is used for calculation of probability expected return.

Formal:

             n

E(R) =  ∑  (Pi * Ri)

            i = 1

Here,

E(R) is expected return.

Pi is probability of i times 

Ri is the rate of outcome.

Let's understand how to calculate expected return with a scenario.

The first scenario is from the Good market, where probability is 50% and return is 12%. In the second scenario the average Market probability is 30% and return is 8%. And in the third scenario a poor Market is there, which has a -4% return with 20% possibility. 

Now the calculation is 

(0.5 × 12) + (0.3 × 8) + (0.2 × -4)

Calculation:

6 +2.4-0.8

Expected Return = 7.6%

Portfolio expected return 

When investors use different assets and get returns they use the expected return formula for the portfolio. 

Formula:

n E(Rp) = ∑(w; × E(R₁) i=1

Here, 

E(Rp) is the return for the whole portfolio.

wi is total portfolio value.

E(R₁) is expected returnn.

Bonus tip - Do you know?Modern investment platforms such as robo-advisors and broker tools present expected returns as a range (e.g., 8–12% per annum with probability).

Importance of Expected Return formula 

Expected return gives idea about future outcomes on current investment by analysing past few records. After knowing about future outcomes, investors can choose investment options. Investors get to know about their target, if they are on track or not like retirement. Here, only real data is used to calculate return, so no guess work. 

Limitations of Expected Return

From the name we can understand the meaning, it is an expected long term average, not a precise outcome. If there is a 10% expected forecast, that doesn't mean there will be an exact 10% loss or profit. It is only expected. The expected return formula uses past outcomes to generate present results. But the market conditions and global situation aren't certain. It changes with time. 

The next thing is that it calculates average outcome and does not calculate exact return. When calculating expected return, if you mistakenly used every small  wrong data, the final result can drastically change. Also, the calculation here is done on a gross basis, they do not include tax, transaction, management fee. That's why the final profit became less than expected.

Conclusion

Investors use the expected return formula to see the probability of outcome. They use this formula to make changes in portfolio and compare opportunities with various assets. But expected returns are not accurate. It is based on assumptions and this tool is still valuable for long term use. 

FAQs 

What is the expected return of an investment in simple terms?

Expected return is calculated by averaging different outcomes, possibilities and probabilities. With the help of expected return investors decide how to and where to invest. 

Why do investors calculate expected return before investing?

Investors calculate expected return before investing to know the performance of an investment. In this formula various assets like mutual fund, bond, and stocks outcomes are compared. By analysing it investors can choose better options.

Is expected return the same as actual return? 

No, absolutely not. Expected return is not the same as actual return. This is only the estimated outcome which is made by previous profit and other data. Real outcomes can be different from expected, like higher or lower because the market can change anytime.

Can expected return be negative?

Yes. Loss can be expected. Expected return shows all the possibilities of outcome like gains and loss. If gains are less than loss then the expected return can be negative. Also, poor economics, bad performance of a company and uncertainty in the market can result in negative expected return. 

How is expected return different from risk?

Expected return is work on average formula. In it outcomes of all the possible returns added and then divided by the total number of outcomes. The real future result can be different from expected return. 

Do professional investors use expected return in portfolio management?

Yes. Professional investors use expected return in portfolio management to control risk.