It is calculated by taking the probability-weighted average of all possible returns, factoring in the likelihood of each outcome. This concept helps investors assess the potential risks and rewards of their investments, guiding decision-making in portfolio management. Expected return is particularly useful when comparing different investment options, as it provides a framework for evaluating which assets may offer better potential returns based on their inherent risks.
Expected return Example
For example, if an investor is considering a stock that has a 50% chance of gaining 10% and a 50% chance of losing 5%, the expected return would be calculated as follows: (0.5 * 10%) + (0.5 * -5%) = 5%. Thus, the investor can expect a 5% return on this stock based on the weighted probabilities of the outcomes.