Understanding Expected Return: A Guide for Investors
Investing is an essential component of financial planning. However, it’s not enough to just put money into an investment; it’s necessary to understand the potential returns on investment. In this guide, we’ll explain what expected return is and how investors can use it to make informed financial decisions.
What is Expected Return?
Simply put, expected return is the estimated profit or loss of an investment. It’s the average return that an investor can expect to receive from an investment, taking into account possible future outcomes that are based on past performance.
Suppose you’re thinking about investing in a stock. The expected return will indicate what you might gain or lose over a given time frame in the future. Expected return is an essential tool for calculating the potential risk-versus-reward ratio of different types of investments.
How is Expected Return Calculated?
Several factors determine the expected return of an investment, including the historical performance of the stock market, the economy, and market trends. It’s essential to consider the following factors when calculating the expected return:
- Historic performance of the market: The historical returns of the stock market over a specific time frame can be used as a reference point.
- The Beta factor: It’s the measure of how closely the investment follows the overall market trends.
- Investment goals and strategy: The expected return may differ based on whether the investment goal is long-term or short-term.
The Significance of Expected Returns
Expected return can help investors in different ways:
- Estimate potential profits: Investors can use expected return to determine the amount of profit they are likely to make on an investment. It can be compared to the investor’s minimum acceptable return.
- Risk assessment: Expected returns provide investors with a clear idea of the possible risks associated with different types of investments.
- Portfolio management: A diversified approach can be taken to portfolio management using expected returns. Investors can select investments that are expected to provide the highest returns while keeping the risk to a minimum.
Examples of Expected Returns
Let’s take an example of a risk-free investment, such as government bonds. Suppose the interest rate on a government bond is 3%. In such a case, the expected return of the investment will also be 3%.
Similarly, an investment in the stock market is always risky, and there is no guaranteed return. The expected return of a stock investment will depend on its past performance, earnings growth prospects, industry trends, and economic outlook, among other factors.
Conclusion
Expected return is a critical tool to help investors estimate potential returns on investments and assess risk levels. It’s important to calculate expected return carefully and consider all the factors that affect it. Investors should use expected return to make informed and strategic investment decisions that align with their overall financial goals.
