The Importance of Calculating Expected Return on Your Investments
Investing money is a great way to build wealth over time. However, investing can also be a risky proposition, and it’s important to understand what the potential return on your investment might be before making any decisions. This is where calculating the expected return becomes critical.
What is Expected Return?
Expected return is a calculation that helps investors understand the potential return they may receive from an investment. This calculation takes into account both the potential upside and downside of an investment, and can help investors determine whether or not an investment is right for their portfolio.
How to Calculate Expected Return
Calculating expected return can be done in a few simple steps. First, you’ll need to determine the potential returns for each possible outcome of the investment. For example, if you’re considering investing in a stock, you’ll need to estimate the potential returns if the stock increases in value, remains steady, or decreases in value.
Once you’ve determined these potential returns, you’ll need to assign a probability to each outcome. This probability reflects the likelihood of each outcome occurring. For example, you might assign a 50% probability to the stock increasing in value, a 30% probability to the stock remaining steady, and a 20% probability to the stock decreasing in value.
Finally, you’ll multiply the potential returns by their corresponding probabilities, and add them all together. This will give you the expected return for the investment.
An Example of Calculating Expected Return
Let’s say you’re considering investing $10,000 in a stock. You estimate that if the stock increases in value, you could potentially earn a 20% return. If the stock remains steady, you estimate you could earn a 5% return, and if the stock decreases in value, you estimate you could lose 10%.
Using these potential returns, you assign a 60% probability to the stock increasing in value, a 30% probability to the stock remaining steady, and a 10% probability to the stock decreasing in value.
To calculate the expected return, you would multiply the potential returns by their corresponding probabilities, and add them together:
(20% * 60%) + (5% * 30%) + (-10% * 10%) = 12%
So, in this example, the expected return for the investment is 12%.
Why Calculating Expected Return is Important
Calculating expected return is important because it helps investors make informed decisions about their investments. By understanding the potential risks and rewards of an investment, they can make decisions that are aligned with their investment goals and risk tolerance.
Furthermore, by calculating expected return, investors can compare the potential returns of different investments to determine which one is the best fit for their portfolio.
Conclusion
Calculating expected return is a critical part of investing. By taking the time to understand the potential risks and rewards of an investment, investors can make informed decisions that are in line with their goals and risk tolerance. Whether you’re a seasoned investor or just starting out, knowing how to calculate expected return can help you build a strong portfolio that can weather the ups and downs of the market.
