Expected return: Explained | TIOmarkets
BY TIO Staff
|July 5, 2024In the world of trading, expected return is a fundamental concept that every trader should understand. It is a key component in the decision-making process and can greatly influence the strategies employed by traders. The expected return is the profit or loss an investor anticipates on an investment that has known or anticipated rates of return. It is calculated by multiplying potential outcomes by the chances of them occurring and then totaling these results.
Understanding expected return is crucial for traders because it provides a measure of the potential profitability of an investment. It allows traders to assess the risk and reward of different investment options and to make informed decisions about where to allocate their resources. Despite its importance, the concept of expected return can be complex and difficult to understand. This article aims to demystify expected return and provide a comprehensive understanding of this critical trading concept.
Understanding Expected Return
The expected return is the anticipated profit or loss from an investment over a specified period. It is a statistical measure and is calculated as the average of the possible returns, each weighted by the likelihood of that return occurring. The expected return is a key input in financial models and is used to price assets and to calculate the cost of capital.
While the expected return provides a measure of the average return, it does not provide any insight into the variability or risk of the return. Therefore, the expected return should always be considered in conjunction with other measures of risk, such as the standard deviation or the beta of the investment.
Calculating Expected Return
The expected return is calculated by multiplying each possible return by the probability of that return occurring and then summing these values. The formula for calculating the expected return is as follows: Expected Return = Sum (Return * Probability).
It's important to note that the expected return is a theoretical value and does not guarantee that this return will be achieved. The actual return may be higher or lower than the expected return due to various factors such as market conditions, changes in interest rates, and company-specific events.
Interpreting Expected Return
The expected return provides a measure of the potential profitability of an investment. A higher expected return indicates a higher potential profit, while a lower expected return indicates a lower potential profit. However, a higher expected return also typically comes with higher risk.
It's also important to note that the expected return is a long-term average return. In the short term, the actual return may deviate significantly from the expected return. Therefore, traders should not rely solely on the expected return when making trading decisions but should also consider other factors such as the risk of the investment and their own risk tolerance.
Expected Return in Portfolio Theory
In modern portfolio theory, the expected return is a key component in determining the efficient frontier, which represents the set of optimal portfolios that offer the highest expected return for a given level of risk. The expected return of a portfolio is calculated as the weighted average of the expected returns of the individual assets in the portfolio, with the weights representing the proportion of the portfolio invested in each asset.
The concept of expected return is also central to the capital asset pricing model (CAPM), which is a model that describes the relationship between risk and expected return. According to the CAPM, the expected return of an asset is equal to the risk-free rate plus a risk premium that is proportional to the asset's beta, which measures its systematic risk.
Expected Return and Risk
While the expected return provides a measure of the potential profitability of an investment, it does not provide any insight into the risk of the investment. Therefore, the expected return should always be considered in conjunction with measures of risk.
The risk of an investment is typically measured by the standard deviation of the returns, which provides a measure of the variability or volatility of the returns. A higher standard deviation indicates a higher risk, while a lower standard deviation indicates a lower risk. Other measures of risk include the beta of the investment, which measures its systematic risk, and the Sharpe ratio, which measures the risk-adjusted return.
Expected Return and Diversification
Diversification is a strategy that involves spreading investments across various financial instruments, industries, and other categories to reduce risk. It can influence the expected return and risk of a portfolio.
By diversifying a portfolio, traders can reduce the risk without necessarily reducing the expected return. This is because the returns of different investments are not perfectly correlated and therefore, the overall risk of the portfolio is less than the weighted average risk of the individual investments. This is known as the diversification benefit.
Limitations of Expected Return
While the expected return is a useful measure of the potential profitability of an investment, it has several limitations. Firstly, the expected return is a theoretical value and does not guarantee that this return will be achieved. The actual return may be higher or lower than the expected return due to various factors.
Secondly, the expected return is a long-term average return and does not provide any insight into the short-term fluctuations in the return. Therefore, the actual return in any given period may deviate significantly from the expected return.
Assumptions and Uncertainties
The calculation of the expected return involves several assumptions and uncertainties. It assumes that the probabilities of the possible returns are known and remain constant over time. However, in reality, these probabilities are often unknown and can change over time due to changes in market conditions and other factors.
Furthermore, the expected return assumes that the returns are normally distributed. However, in reality, returns are often not normally distributed and can exhibit skewness and kurtosis. This can lead to significant deviations from the expected return.
Use in Decision Making
Despite its limitations, the expected return is a valuable tool in decision making. It provides a measure of the potential profitability of an investment and can be used to compare different investment options. However, traders should not rely solely on the expected return when making trading decisions but should also consider other factors such as the risk of the investment and their own risk tolerance.
In conclusion, the expected return is a fundamental concept in trading and is a key component in the decision-making process. Understanding expected return can greatly influence the strategies employed by traders and can lead to more informed and effective trading decisions.
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