Expected return is the profit or loss an investor anticipates on an investment that has known historical rates of return (RoR). Its calculation does not only apply to a single value or asset. It can also be expanded to analyze a portfolio containing different investments. Let's see how we can use the expected profitability to our advantage and the factors to take into account.
What is expected profitability
The expected return is the profit or loss an investor anticipates on an investment that has known historical rates of return (RoR). Is calculated multiplying the potential outcomes by the probabilities of their occurrence and summing these outcomes.
What is expected profitability for?
The calculation of expected profitability is a key piece of both business operations and financial theory, even in the well-known financial models. modern portfolio theory (MPT) or the Black-Scholes option pricing model. The expected return is a tool used to determine whether an investment has a positive or negative average net result. It is calculated as the expected value (EV) of an investment given its potential profitability in different scenarios. The expected profitability usually based on historical data and, therefore, is not guaranteed in the future; however, usually sets reasonable expectations. Therefore, the expected return figure can be viewed as a long-term weighted average of historical returns.
Expected profitability model. Source: Investment Moats.
Formula for calculating expected profitability
The expected profitability and the standard deviation are two statistical measures that can be used to analyze a portfolio. The expected return of a portfolio is the expected amount of return a portfolio can generate, which makes it the mean (average) of the possible return distribution of the portfolio. When considering individual investments or portfolios, a more formal equation for the expected return on a financial investment is:
Formula for calculating expected profitability.
In essence, this formula states that the expected return in excess of the risk-free rate of return depends on the investment's beta, or relative volatility compared to the broader market.
Example of calculating expected profitability
This calculation It does not only apply to a single security or asset. It can also be expanded to analyze a portfolio containing different investments. If the expected profitability of each investment is known, the overall expected profitability of the portfolio is a weighted average of the expected returns of its components. For example, suppose we take three shares of the Investment Ideas Substack blog:
Salesforce (CRM): $5.000 invested and an expected return of 15%.
FedEx Corp (FDX): $2.000 invested and an expected return of 6%.
Accenture Plc. (ACN): $3.000 invested and an expected return of 9%. With a total portfolio value of $10.000, the weightings of Salesforce, FedEx Corp. and Accenture Plc. in the portfolio they are 50%, 20% and 30%, respectively. Therefore, the expected return on the total portfolio is:
(50% x 15%) + (20% x 6%) + (30% x 9%) = 11,4%.
Limitations of the expected profitability calculation
Making investment decisions based solely on expected return calculations can be quite risky. Before making any investment decision, We should always review the risk characteristics of investment opportunities to determine whether investments fit our portfolio objectives. For example, suppose we propose two hypothetical investments. Its annual profitability results in the last five years are:
Investment A: 12%, 2%, 25%, -9% and 10%.
Investment B: 7%, 6%, 9%, 12% and 6%. Both investments have expected returns of exactly 8%. However, when analyzing the risk of each one, defined by the standard deviation, Investment A is approximately five times riskier than Investment B. That is, investment A has a standard deviation of 11,26% and investment B has a standard deviation of 2,28%. In addition to the expected returns, We must also take into account the probability of occurrence. After all, there may be cases in which certain assets offer a positive expected return, even though the probabilities of this occurring are very low.