What is Expected Return?
The Expected Return measures the anticipated return on an investment or portfolio of securities, expressed in the form of a percentage.
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How to Calculate Expected Return
By measuring the expected return on a probability-weighted basis, investors can estimate the return from an investment or portfolio of securities.
In corporate finance, the expected return of a portfolio signifies the anticipated yield that could potentially be generated over a pre-defined time frame.
Understanding the expected risk-adjusted return on a portfolio contributes to more informed investment decisions, where the risk-return profile of the investment can be structured to more closely align with the investor’s risk appetite and target yield.
The expected return is a critical component to constructing a portfolio that can generate the target return while mitigating risk to a manageable level.
The expected return is calculated by multiplying the probability of each possible return scenario by its corresponding value and then adding up the products.
The expected return metric – often denoted as “E(R)” – considers the potential return on an individual security or portfolio and the likelihood of each outcome.
However, the implied return is not merely a simple average but rather a range of potential outcomes, which facilitates a more comprehensive assessment of the risk-reward profile of the investment portfolio.
The incorporation of probability weights in analyzing potential returns improves the depth of the decision-making process for investors, especially with regard to understanding the potential upside and downside of an investment portfolio, akin to performing scenario analysis.
Expected Return Formula
The formula to calculate the expected return on an individual security, or “cost of equity”, is determined using the capital asset pricing model (CAPM), which adds the product of beta (β) and the equity risk premium (ERP) to the risk-free rate (rf).
Where:
- Risk-Free Rate (rf) → The risk-free rate is the yield on the debt issuances by the government, e.g. the 10-year Treasury note for U.S.-based public companies.
- Beta (β) → Beta is the measure of systematic risk, i.e. the volatility of a security to the broader market, which represents non-diversifiable risk.
- Equity Risk Premium (ERP) → The equity risk premium, or “market risk premium” is the extra, incremental return expected from investors for investing in the stock market rather than risk-free securities.
The risk-free rate and beta are readily observable via Bloomberg and related online sources, and the equity risk premium (ERP) is computed as the difference between the expected market return and the risk-free rate.
Further, the formula to calculate the expected return on a portfolio requires weighting each potential outcome by its probability and then adding together these weighted returns.
Where:
- Σ → Summation Notation
- p(i) → Probability of Outcome
- r(i) → Return in Outcome
Expected Return Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
