Assume that the expected returns for X, Y, and Z have been calculated and found to be 15%, 10%, and 20%, respectively. $2,000 is invested in X, $5,000 invested in Y, and $3,000 is invested in Z. To illustrate the expected return for an investment portfolio, let’s assume the portfolio is comprised of investments in three assets – X, Y, and Z. Examining the weighted average of portfolio assets can also help investors assess the diversification of their investment portfolio. Components are weighted by the percentage of the portfolio’s total value that each accounts for. The expected return for an investment portfolio is the weighted average of the expected return of each of its components. It can also be calculated for a portfolio.
Calculating Expected Return of a PortfolioĬalculating expected return is not limited to calculations for a single investment. Therefore, the probable long-term average return for Investment A is 6.5%. 3, probability of a return of negative 5%, or -.5) The expected return on investment A would then be calculated as follows:Įxpected Return of A = 0.2(15%) + 0.5(10%) + 0.3(-5%) Assume that it generated a 15% return on investment during two of those 10 years, a 10% return for five of the 10 years, and suffered a 5% loss for three of the 10 years. The probabilities stated, in this case, might be derived from studying the performance of the asset over the previous 10 years. The probabilities of each potential return outcome are derived from studying historical data on previous returns of the investment asset being evaluated. This is an example of calculating a discrete probability distribution for potential returns. Let us take an investment A, which has a 20% probability of giving a 15% return on investment, a 50% probability of generating a 10% return, and a 30% probability of resulting in a 5% loss. Δ Calculating Expected Return for a Single Investment
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A distribution of the height of adult males, which can take any possible value within a stated range, is a continuous probability distribution.Įxpected Return Download the Free TemplateĮnter your name and email in the form below and download the free template now! Tossing a coin has two possible outcomes and is thus an example of a discrete distribution. A random variable following a continuous distribution can take any value within the given range. Discrete distributions show only specific values within a given range. Distributions can be of two types: discrete and continuous. It is confined to a certain range derived from the statistically possible maximum and minimum values.
Basics of Probability Distributionįor a given random variable, its probability distribution is a function that shows all the possible values it can take. Treasury bills is often used to represent the risk-free rate of return. This gives the investor a basis for comparison with the risk-free rate of return. The purpose of calculating the expected return on an investment is to provide an investor with an idea of probable profit vs risk. Expected return is simply a measure of probabilities intended to show the likelihood that a given investment will generate a positive return, and what the likely return will be. The expected return is based on historical data, which may or may not provide reliable forecasting of future returns. In the short term, the return on an investment can be considered a random variable that can take any values within a given range. Expected return is calculated by multiplying potential outcomes (returns) by the chances of each outcome occurring, and then calculating the sum of those results (as shown below). The return on the investment is an unknown variable that has different values associated with different probabilities. The expected return on an investment is the expected value of the probability distribution of possible returns it can provide to investors.
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