Expected Return of A = 0.2 (15%) + 0.5 (10%) + 0.3 (-5%) (That is, a 20%, or.2, probability times a 15%, or.15, return; plus a 50%, or.5, probability times a 10%, or.1, return; plus a 30%, or.3, probability of a return of negative 5%, or -.5) = 3% + 5% – 1.5% = 6.5% Therefore, the probable long-term average return for Investment A is 6.5%.
Full Answer
What is the expected rate of return?
An expected rate of return is the return on investment you expect to collect when investing in a stock. So, for comparison purposes, the RRR is the minimum possible rate that would entice you to invest, and the expected rate of return is what you actually plan to make from that investment. This rate is calculated based on probability.
What is the expected return of each stock in my portfolio?
Stock A makes up 25% of your portfolio and has an expected return of 7%. Stock B makes up 40% of your portfolio and has an expected return of 5%. Stock C makes up 35% of your portfolio and has an expected return of 8.5%. To calculate the expected return of your portfolio, use the following calculation:
What is the expected long-term average return for investment a?
(That is, a 20%, or .2, probability times a 15%, or .15, return; plus a 50%, or .5, probability times a 10%, or .1, return; plus a 30%, or .3, probability of a return of negative 5%, or -.5) Therefore, the probable long-term average return for Investment A is 6.5%. Calculating expected return is not limited to calculations for a single investment.
What is the purpose of calculating the expected return on investment?
The purpose of calculating the expected return on an investment is to provide an investor with an idea of probable profit vs risk. This gives the investor a basis for comparison with the risk-free rate of return.
What is the expected return on a stock?
Expected return and standard deviation are two statistical measures that can be used to analyze a portfolio. The expected return of a portfolio is the anticipated amount of returns that a portfolio may generate, making it the mean (average) of the portfolio's possible return distribution.
What is expected return quizlet?
What is the definition of expected return? It is the return that an investor expects to earn on a risky asset in the future. If investors are risk averse, it is reasonable to assume that the risk premium for the stock market will be: positive.
How do you calculate expected return?
Expected return is calculated by multiplying potential outcomes by the odds that they occur and totaling the result....Expected return = (return A x probability A) + (return B x probability B).First, determine the probability of each return that might occur. ... Next, determine the expected return for each possible return.More items...
What is the expected return of the portfolio quizlet?
About 2/3 of the time, the realized return on Stock A will be between 14% and 16%. The expected return on a portfolio is equal to the weighted average of the returns on the assets within the portfolio.
What two factors determine a stock's total return quizlet?
2 factors that determine a stock's total return? R stands for the actual total return in the year, E(R) stands for the expected part of the return and U stand for the unexpected part of the return. Amount of the systematic risk present in a particular risky asset relative to that in an average risky asset.
What two factors determine a stock's total return?
The total return for all investments, in our view, is made up of the yield and the price change, or capital appreciation or depreciation, of the security, whether that security is a stock or a bond.
How do you calculate expected stock price?
In order to determine the future expected price of a stock, you start off by dividing the annual dividend payment by the current stock price. For example, if a stock is currently priced at $80 and offers a $3 annual dividend, you would then divide $3 by $80 to get 0.0375.
How do you calculate the expected return on a stock in Excel?
In cell F2, enter the formula = ([D2*E2] + [D3*E3] + ...) to render the total expected return....Key TakeawaysEnter the current value and expected rate of return for each investment.Indicate the weight of each investment.Calculate the overall portfolio rate of return.
How do you find the expected return of a stock with beta?
Expected return = Risk Free Rate + [Beta x Market Return Premium] Expected return = 2.5% + [1.25 x 7.5%] Expected return = 11.9%
What is a portfolio quizlet?
Portfolios. A collection of Assets (each asset will have its own level of potential risk and reward) The Expected Return of a Portfolio.
How is stock risk measured?
Beta and standard deviation are two tools commonly used to measure stock risk. Beta, which can be found in a number of published services, is a statistical measure of the impact stock market movements have historically had on a stock's price.
What is a diversified portfolio quizlet?
Portfolio Diversification. a risk management technique that mixes a wide variety of investments within a portfolio. it is the spreading out of investments to reduce risks.
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What is expected return?
Expected return and standard deviation are two statistical measures that can be used to analyze a portfolio.
What is standard deviation in portfolio?
Standard deviation of a portfolio, on the other hand, measures the amount that the returns deviate from its mean, making it a proxy for the portfolio's risk. Expected return is not absolute, as it is a projection and not a realized return.
Is expected return based on historical data?
The expected return is usually based on historical data and is therefore not guaranteed into the future; however, it does often set reasonable expectations. Therefore, the expected return figure can be thought of as a long-term weighted average of historical returns .
Is expected return dangerous?
Limitations of Expected Return. To make investment decisions solely on expected return calculations can be quite naïve and dangerous. Before making any investment decisions, one should always review the risk characteristics of investment opportunities to determine if the investments align with their portfolio goals.
What is expected return theory?
that can take any values within a given range. The expected return is based on historical data, which may or may not provide reliable forecasting of future returns. Hence, the outcome is not guaranteed.
What are the two types of distributions?
Distributions can be of two types: discrete and continuous. Discrete distributions show only specific values within a given range. A random variable following a continuous distribution can take any value within the given range. Tossing a coin has two possible outcomes and is thus an example of a discrete distribution.
What is a probability distribution?
For a given random variable, its probability distribution is a function that shows all the possible values it can take. It is confined to a certain range derived from the statistically possible maximum and minimum values. Distributions can be of two types: discrete and continuous. Discrete distributions show only specific values within a given range. A random variable following a continuous distribution can take any value within the given range. Tossing a coin has two possible outcomes and is thus an example of a discrete distribution. A distribution of the height of adult males, which can take any possible value within a stated range, is a continuous probability distribution.
Is tossing a coin a discrete distribution?
Tossing a coin has two possible outcomes and is thus an example of a discrete distribution. A distribution of the height of adult males, which can take any possible value within a stated range, is a continuous probability distribution. Expected Return.
Is expected return a predictor of stock performance?
Although not a guaranteed predictor of stock performance, the expected return formula has proven to be an excellent analytical tool that helps investors forecast probable investment returns and assess portfolio risk and diversification.
How to calculate expected return?
The expected return of a portfolio is calculated by multiplying the weight of each asset by its expected return and adding the values for each investment.
What is expected return and standard deviation?
The expected return of a portfolio is the anticipated amount of returns that a portfolio may generate, whereas the standard deviation of a portfolio measures the amount that the returns deviate from its mean.
What is standard deviation in investing?
An investor uses an expected return to forecast, and standard deviation to discover what is performing well and what is not.
Why do investors require compensation for taking on risk?
Investors require compensation for taking on risk, because they might lose their money. If the risk-free rate is 0.4 percent annualized, and the expected market return as represented by the S&P 500 index over the next quarter year is 5 percent, the market risk premium is (5 percent - (0.4 percent annual/4 quarters per year)), or 4.9 percent.
What is the beta of an asset?
Beta is a measure of how an asset's price moves in conjunction with price changes in the market. A β with a value of +1 indicates perfect positive correlation: The market and asset move in lockstep on a percentage basis. A β of -1 indicates perfect negative correlation -- that is, if the market goes up 10 percent, the asset would be expected to fall 10 percent. The betas of individual assets, such as mutual funds, are published on the issuer's website.
What is CAPM in investing?
You can use the capital asset pricing model, or CAPM, to estimate the return on an asset -- such as a stock, bond, mutual fund or portfolio of investments -- by examining the asset's relationship to price movements in the market. Advertisement.
What are the variables used in CAPM?
The variables used in the CAPM equation are: Risk-free rate (r f ), the interest rate available from a risk-free security, such as the 13-week U.S. Treasury bill. No instrument is completely without some risk, including the T-bill, which is subject to inflation risk. However, the T-bill is generally accepted as the best representative ...
What is expected rate of return?
Expected Rate of Return. An expected rate of return is the return on investment you expect to collect when investing in a stock. So, for comparison purposes, the RRR is the minimum possible rate that would entice you to invest, and the expected rate of return is what you actually plan to make from that investment.
What is the difference between expected rate of return and required rate of return?
Essentially, the required rate of return helps you decide if an investment is worth the cost, and an expected rate of return helps you figure out how much you can reasonably expect to make from that investment.
Why is it important to factor in risk and market volatility?
This is because risk-free investments are available through the U.S. government in the form of securities, such as bonds.
What is expected return?
The expected return of an investment is the rate of return an investor can reasonably expect, based on historical performance. You can use an expected-return formula to estimate the profit or loss on a specific stock or fund.
Why is expected return important?
Expected return can be an effective tool for estimating your potential profits and losses on a particular investment. Before diving in, it’s important to understand the pros and cons. Pros. Helps an investor estimate their portfolio’s return. Can help guide an investor’s asset allocation.
What does it mean when a stock has a low standard deviation?
When a stock has a low standard deviation, its price stays relatively stable, and returns are usually close to the average. A high standard deviation indicates that a stock can be quite volatile.
Is expected return based on historical performance?
The expected return is based entirely on historical performance. There’s no guarantee that future returns will compare. It also doesn’t take into account the risk of each investment. The expected return of an asset shouldn’t be the only factor you consider when deciding to invest.
Can you use expected and required return in tandem?
You can use the required return and expected return in tandem. When you know the required rate of return for an investment , you can use the expected return to decide if it’s worth your while.
What is the Expected Rate of Return?
The expected rate of return is the return on investment that an investor anticipates receiving. It is calculated by estimating the probability of a full range of returns on an investment, with the probabilities summing to 100%.
Example of the Expected Rate of Return
An investor is contemplating making a risky $100,000 investment, where there is a 25% chance of receiving no return at all. There is also a 50% probability of generating a $10,000 return, and a 25% chance that the investment will create a $50,000 return. Based on this information, the expected rate of return is:
