Expected Rate of Return

The Expected Rate of Return, also known as the Expected Return, is a measure used to estimate
the average rate of return that an investment or asset is expected to generate in the future. It is
calculated by considering the probabilities of different possible outcomes and their associated
returns.
The formula to calculate the expected rate of return is:
Expected Rate of Return = (Return1 × Probability1) + (Return2 × Probability2) + ... + (Returnn
× Probabilityn)
Where: Return1, Return2, ..., Returnn: The potential returns associated with different outcomes.
Probability1, Probability2, ..., Probabilityn: The probabilities assigned to each respective
outcome.
To calculate the expected rate of return, you multiply each possible return by its corresponding
probability and sum up these values.
For example, let's consider an investment that has two possible outcomes with associated returns
and probabilities:
Outcome 1: Return of 10% with a probability of 0.6 (60%) Outcome 2: Return of -5% with a
probability of 0.4 (40%)
Using the formula, the expected rate of return can be calculated as follows:
Expected Rate of Return = (0.10 × 0.6) + (-0.05 × 0.4) Expected Rate of Return = 0.06 + (-0.02)
Expected Rate of Return = 0.04 or 4%
Therefore, the expected rate of return for this investment is 4%. This means that, on average, you
can expect to earn a 4% return over the long run, considering the probabilities assigned to each
potential outcome.
The expected rate of return is a useful metric for investors as it provides an estimation of the
average performance of an investment, helping them make informed decisions and assess the
risk-reward tradeoff of different investment options.
Example question
Scenario 1: There is a 40% chance of a 10% return. Scenario 2: There is a 30% chance of a 5%
return. Scenario 3: There is a 30% chance of a -2% return.
To calculate the expected rate of return, you multiply each return by its corresponding
probability and sum up the results:
Expected Rate of Return = (0.10 × 0.40) + (0.05 × 0.30) + (-0.02 × 0.30) Expected Rate of
Return = 0.04 + 0.015 - 0.006 Expected Rate of Return = 0.049 or 4.9%
Therefore, the expected rate of return for this stock investment is 4.9%. This means that, on
average, you can expect to earn a 4.9% return over the next year, considering the probabilities
assigned to each scenario.