Expected rate of return is a calculated in form of percentage. It is an expected percentage of return which is earned by an investor in the defined period. In other words, It is a profit percentage on return which is calculated in percentage on the value of investments made for a specific period.
The return on investment is the return which an investor anticipates receiving after particular period of time. Period may be in the form of month, year or quarter.
It is basically profit and loss of an investor predict for an investment that is also known as expected rates of return i e.RoR.
Expected rate of return (ERR) is usually calculated by formula either using a historical data of performance of investment or a with weighted average resulting all possible outcomes.
- An investor is making a $10,000 investment, where there is a 25% chance of receiving return on investment then ERR is $2500. e. $10,000 x 25% = $2,500.
- An investor is making a risky investment of $10,000, there is a no chance of receiving return is 10%.and there is a probability of 50% of generating on $1,000 return, and a 40% chance create a $5,000 return. Based on this information, the expected rate of return is:
$0 return x 10% = $0 return
$1000 return x 50% = $500
$5000 return x 40% = $2000
So Expected rate of return (ERR) is calculated as $2,500.
Expected Return. You divide your investment in number of chances. For example in below we had divided the investment into two parts 10% and 90%. In 10% part of our investment, we had 100% chance of getting return on investment and in 90% part of our investment, we had 50% chance of getting return on investment.
|Chance||Return||Chance x Return|
The Formula for rate of return is calculated as shown below.
|Rate of Return =||Amount Received – Amount Invested|
Expected rate of return which we called are ERR can is calculated by one of the method with weighted average rate of return which is all possible outcomes. Formula for which is as below.
ERR = p1×r1 + p2×r2 + p3×r3 + … + pn×rn
where pi = Probability of i th outcome
ri = rate of return achieved at i th outcome
n = number of possible outcomes.
Historical Return Approach
Many a times Historical return Approach is used to assess expected rate of return for calculating performance of investment of an investor.
ri = Actual % return of investment got in the ith period
n = number of periods in a historical data.
Expected Rate of Return for a Portfolio
When there is a several investments in portfolio, so to calculate expected return percentage is basically weighted average all rate of returns according to their ratio.
wi = proportion of i th investment of a portfolio
ERR =Rate of return of i th of investment,
n = number of a portfolio’s classes.
Why Expected Return Return calculated ?
This is basically tool which is used to determine whether this investment has a negative or a positive on a result of investment.
- It calculate Profit or Loss on an investor
- It is calculated by a multiplying with the possible outcomes
- Fundamentally a weighted average of long-term possible historical results, many a time expected returns are not assured.
Short coming of Expected Return
To decide on investment just on the basis of alone on expected returns. Before investing and making decisions on investment. Investors should review each and every characteristics of an investment. Mainly risk , News and Market trends. Future opportunities in order to determine if investments are straight line in our portfolio objective.
- Investment X: 10%, 3%, 20% and -8%
- Investment Y: 6%, 5%, 8% and 10%
Above two investments had an expected returns approx 6%. But when analyze the each of the risk, by the method of standard deviation then Investment X is roughly five times failure than Investment Y. That is, Investment X has a standard deviation of 10% and Investment Y has a standard deviation of 1.6%.
Dependence on Past performance Data
Usually, An expected rate of return is usually based on a historical data and it is therefore, is not a guaranteed. This number which is a merely a weighted and a long-term type of historical return average.
Considering with above an example, The expected rate of return of 5% it may never come a true because the amount of investment is a subject to systematic and an unsystematic risks. Here is a systematic risk is in the danger to a market sector or entire market in itself, whereas a unsystematic risk is basically limited to a particular type of company or a industry.
Benefits of Knowing Expected Rate of Returns.
The main benefits of knowing Expected rate of Returns is the amount of investment which we need to add in our port folio. It helps us to know the amount which we will be getting after the specified period. This helps us to know the amount which we will be getting after the investment period in over.
- To know best available option and to select which is best
- To know the future amount which we will be getting if amount is further invested.
- To know the movement of fund in terms of return
- To know account the correct revenue in the books of account.
- To know the available use of cash resource.
In calculating Expected Rate of Return with the above formula for your port folio. You should also take into consideration other factors which are involving with the investment.
Each investor should be smart enough to understand the Market Senerio. Expected rate of return depends to other non measurable factors. Owner of the company or portfolio which we are investing. News which are trends related to this investment.
Owner of the company or the instrument in which we are investing are in the hands of genuine person. Person who had a good trend and a experience in growth of a company. That person will definitely grow our investment.
Expected Rate of Return is measurable but with the other positive condition will add value in the advantage in decision of investment.