The return on the investment is an unknown variable that has different values associated with different probabilities. The expected return on the portfolio will then be: The weight of any stock is the ratio of the amount invested in that stock to the total amount invested. w 1 = proportion of the portfolio invested in asset 1. Based on the respective investments in each component asset, the portfolio’s expected return can be calculated as follows: Expected Return of Portfolio = 0.2(15%) + 0.5(10%) + 0.3(20%) = 3% + 5% + 6% = 14%. The equation for its expected return is as follows: Expected Return=WA×RA+WB×RB+WC×RCwhere:WA = Weight of security ARA = Expected return of security AWB = Weight of security BRB = Expected return of security BWC = Weight of security CRC = Expected return of security C\begin{aligned} &\text{Expected Return}=WA\times{RA}+WB\times{RB}+WC\times{RC}\\ &\textbf{where:}\\ &\text{WA = Weight of security A}\\ &\text{RA = Expected return of security A}\\ &\text{WB = Weight of security B}\\ &\text{RB = Expected return of security B}\\ &\text{WC = Weight of security C}\\ &\text{RC = Expected return of security C}\\ \end{aligned}Expected Return=WA×RA+WB×RB+WC×RCwhere:WA = Weight of security ARA = Expected return of security AWB = Weight of security BRB = Expected return of security BWC = Weight of security CRC = Expected return of security C. In this article, we will learn how to compute the risk and return of a portfolio of assets. Beta is a measure of the volatility, or systematic risk, of a security or portfolio in comparison to the market as a whole. 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. However, when each component is examined for risk, based on year-to-year deviations from the average expected returns, you find that Portfolio Component A carries five times more risk than Portfolio Component B (A has a standard deviation of 12.6%, while B’s standard deviation is only 2.6%). Calculating expected return is not limited to calculations for a single investment. 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. expected return of investment portfolio = 6.5% Calculating the expected return for both portfolio components yields the same figure: an expected return of 8%. The expected return for an investment portfolio is the weighted average of the expected return of each of its components. This lesson will discuss the technical formulas in calculating portfolio return with practical tips for retail investors. Expected return is just that: expected. Join 350,600+ students who work for companies like Amazon, J.P. Morgan, and Ferrari. You can then plug these values into the formula as follows: expected return of investment portfolio = 0.2(10%) + 0.2(15%) + 0.3(5%) expected return of investment portfolio = 2% + 3% + 1.5%. Learn step-by-step from professional Wall Street instructors today. Note that although the simple average of the expected return of the portfolio’s components is 15% (the average of 10%, 15%, and 20%), the portfolio’s expected return of 14% is slightly below that simple average figure. To do this we must first calculate the portfolio beta, which is the weighted average of the individual betas. The index is a a fruit basket. The expected return of an investment is the expected value of the probability distribution of possible returns it can provide to investors. In the short term, the return on an investment can be considered a random variableRandom Walk TheoryThe Random Walk Theory or the Random Walk Hypothesis is a mathematical model of the stock market. The investor does not use a structural view of the market to calculate the expected return. Therefore, the probable long-term average return for Investment A is 6.5%. It is most commonly measured as net income divided by the original capital cost of the investment. Calculate the Portfolio Return. You may withdraw your consent at any time. Basis risk is the risk that the futures price might not move in normal, steady correlation with the price of the underlying asset, so as to negate the effectiveness of a hedging strategy in minimizing a trader's exposure to potential loss. Thus, an investor might shy away from stocks with high standard deviations from their average return, even if their calculations show the investment to offer an excellent average return. By using Investopedia, you accept our. It is a measure of the center of the distribution of the random variable that is the return. A distribution of the height of adult males, which can take any possible value within a stated range, is a continuous probability distribution. Say your required return is 8% and there are two corner portfolios, P1 with a 10% expected return and P2 with a 7% expected return respectively. CFI's Investing for Beginners guide will teach you the basics of investing and how to get started. This gives the investor a basis for comparison with the risk-free rate of return. R p = w 1 R 1 + w 2 R 2. It is used in the capital asset pricing model. A multi-factor model uses many factors in its computations to explain market phenomena and/or equilibrium asset prices. It is most commonly measured as net income divided by the original capital cost of the investment. And as expected returns are backward-looking, they do not factor in current market conditions, political and economic climate, legal and regulatory changes, and other elements. To calculate a portfolio's expected return, an investor needs to calculate the expected return of each of its holdings, as well as the overall weight of each holding. As a well-informed investor, you naturally want to know the expected return of your portfolio—its anticipated performance and the overall profit or loss it's racking up. Advance your Finance knowledge can invest in are weighted by the original capital of... To consider the specific existing economic or investment climate conditions that are.. On previous returns of the capital asset pricing model portfolio expected return formula investment climate conditions that are.... 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