Expected Returns

What Is Expected Return?

The expected return on an investment is the anticipated profit or loss over a specific period. It is expressed as a percentage of the initial investment and considers the appreciation (or depreciation) of assets and capital as well as any income received during the period, such as dividends or interest. Expected returns are usually calculated using historical performance data, which may not provide reliable forecast, and therefore should only be considered as guidance for probable future outcomes rather than as guaranteed returns. In addition, actual returns can also be influenced by market volatility, economic changes, sector or industry trends, and/or company-specific issues (also called idiosyncratic risk).

Understanding Expected Return

Calculating the expected return on an investment is fundamental in financial theory. Asset allocation models such as the Black-Litterman model and those that analyze the risk and return of an asset/portfolio such as Modern Portfolio Theory, both use expected return estimates. However, the idea of measuring expected return is to provide guidance for the likelihood of the return that a given investment will generate over a specific period rather than offering absolute certainty of that estimate. For example, in the asset management industry, portfolio managers may attempt to attract inflow of capital into their products by providing investors with an overly optimistic estimate of their expected return.

Calculating Expected Return

Calculating Expected Return for a Single Investment

The formula to calculate the expected return on an individual security uses the Capital Asset Pricing Model (CAPM), which essentially adds the product of beta and the equity risk premium (i.e. the return of the market less the risk-free rate) to the risk-free rate.

Formula:

Where:

Ra = the expected return of an investment

Rf = the risk-free rate of return

Βa = the beta of the investment

Rm = the expected market return

(Rm-Rf) = equity risk premium

Calculating Expected Return of a Portfolio

The formula to calculate the expected return on a portfolio essentially requires multiplying the weight of each asset by its expected return.

Formula:

Where:

Rp = the expected return of the portfolio

Wn = the portfolio weight of each asset

Rn = the expected return of each asset

Expected Return Example

Below is an example of a portfolio that includes different securities and their individual weightings in the portfolio. Using the expected return for each security, we can calculate the expected return for the whole portfolio.

Solution

Additional Example

In the example below, we show BlackRock’s 10-year estimate of the expected returns on different equity instruments. The calculation is conditional on different economic scenarios and if a particular scenario actually occurs, actual returns could deviate significantly from the forecast – something touched on when discussing the limitations of expected returns further on in the blog. Furthermore, expectations are calculated on a gross of fees basis and fees and charges may cause further deviation from the estimates. Investors would usually use the below expectations on returns and volatility as a guidance to complement their strategic outlook (as the numbers are long-term) and would not intend to use them as an indication of a strategy’s future performance.

Source: BlackRock Investment Institute, May 2024. Data as of 28 March 2024.

Analyzing Investment Risk

The most common statistical metric used by investment professionals to analyze and measure the risk associated with an investment is standard deviation.  This involves measuring the volatility of an investment’s returns, where a higher standard deviation signifies greater volatility of returns and therefore higher risk. This metric allows investors to compare the risk levels of different investments, but it should be carefully considered only against investments with similar features. For example, if used to analyze a small cap stock that operates in the US technology, the relevant peers to compare against would be also companies that feature in that market segment and have a similar industry/or sub-sector focus (for example chip making).

There are also other metrics that investors use to analyze risk such as:

• Beta – it measures an investment’s volatility relative to that of the overall market. A reading higher than 1 indicates higher volatility than the market, where a beta of less than 1 signals lower volatility
• Value at Risk (VaR) – It estimates the maximum potential loss for an investment over a specific period, given a certain level of confidence
• Sharpe Ratio – It is a measure of risk-adjusted return, which compares the excess return of an investment to its standard deviation

Limitations of the Expected Return

Although it is a useful measure for estimating the potential performance of an investment, expected returns have several limitations. They typically rely on assumptions about future market conditions (which may not hold true) and use historical performance data, for example to calculate a company’s beta within CAPM. Along with the uncertainty of achieving the expected return estimates, the volatility associated with the investment is not factored in is expected returns are considered in isolation. The expected return calculation also assumes that returns are normally distributed, but in reality, they can exhibit skewness (a statistical measure that characterizes the asymmetry of a data distribution), which may result in inaccurate estimates. Costs and charges are typically not included in the calculation, which may also influence the accuracy of the estimate.

Other aspects that are qualitative in nature and can influence performance (but are not reflected in as they are difficult to quantify) include the quality of management and competitive landscape as well as regulatory changes.

Conclusion

To sum up, the expected return of an asset or a portfolio is typically used as guidance and can assist investors in comparing the potential returns of different investments. It also plays an important role in various financial asset allocation and risk models. However, it uses historical data, which may not be a good predictor for future performance. In addition, it is crucial for investors to also consider the risk characteristics of an investment along with its expected return as similar anticipated outcomes may come with different levels of volatility.