Expected return

The expected return of an investment is exactly what it says. The return on most investments is uncertain, however it is possible to describe the future returns statistically as a probability distribution. The mean of this distribution is the expected return.

Take a very simplified example. Suppose we know that a particular security will, over the next year, either:

  • rise 25%, with a 50% probability that this will happen, or
  • fall 20% with a 50% probability

Then:

Expected return = (25% ×50%) - (20% ×50%) = 2.5%

For a real security the possible returns are more numerous. The above example is also unrealistic in that the expected return can not actually occur itself. In most real cases not only can the expected return occur, but it is likely to be fairly close to the most likely level of return.

While there is a risk to expected returns, what matters to investors is not the risk to returns on the security (i.e. the volatility of that security) but the part of that volatility that correlates with movements in the market. This is because the impact on a portfolio of volatility that is not correlated with movements in the market can be diluted to insignificant levels by diversification. Volatility that correlates with the market cannot be. This risk is measured by a security's beta.

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