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Accounting & Finance, Investment

What is Expected Return? How to calculate it

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The expected return (also known as expected gain) is the profit or loss that an investor anticipates on an investment that has known historical rates of return (RoR). It is calculated by multiplying potential outcomes by the chances of them occurring and then totaling these results.

Understanding Expected Return

First, profit (or loss), in economics, is the part of assets that investors receive through investment after deducting costs related to that investment, profit will include opportunity costs. Profit in accounting is basically understood as the difference between the selling price and the cost of goods sold. In fact, from the stated definition of profit in accounting, people are only interested in monetary costs, but not in opportunity costs as in economics. In economics, in a state of perfect competition, profit will be zero. It is also because of this difference that in practice leads to two concepts of profit: economic profit and accounting profit.

The expected return is basically understood as the return from the initial investment. The expected return is actually the percentage that the investors receive between the profit earned and the value of the invested capital. The higher the rate of return, the higher the profit that investors receive.

In the stock market, it is very difficult for investors to figure out the exact expected return. But, by analyzing stock history and overall market trends, investors can anticipate the return value over a period of time. The pre-determining of profit and loss helps investors come up with the best financial plans.

Key Takeaways

According to Investopia:

  • The expected return is the amount of profit or loss an investor can anticipate receiving on an investment.
  • An expected return is calculated by multiplying potential outcomes by the odds of them occurring and then totaling these results.
  • Expected returns cannot be guaranteed.
  • The expected return for a portfolio containing multiple investments is the weighted average of the expected return of each of the investments.

How to calculate Expected Return

Here is a basic formula:

R_{E} = \sum_{i=1}^{n}(R_{i}P_{i})

Where,

  • R_{E} is Expected Return
  • R_{i} indicates each known return
  • P_{i} indicates each probability respective to the R_{i} in the series

For example, if an investment has a 50% chance of gaining 20% and a 50% chance of losing 10%, the expected return would be 5%, explained as below:

50% x 20% + 50% x -10% = 5%

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