For every investor, it is important to learn as much as possible before making financial decisions. An investor would like to know the expected return of its portfolio, its anticipated performance as well as the overall profit or loss it’s racking up. Investors should not forget that the expected return is just that: expected. It is not guaranteed, as it is based on historical returns as well as used to generate essay, but it is not a prediction.
It is not that hard to calculate the expected return of a portfolio. The person needs to know the expected return of each of the securities in his portfolio and the overall weight of each security in the portfolio. That means the person needs to add up the weighted averages of each security’s anticipated rates of return (RoR).
Importantly, an investor bases the estimates of the likely return of security on the assumption that what has been proven true in the past will continue so in the future. This person doesn’t use a structural view of the market to calculate the expected return. Instead, he or she locates the weight of each security in the portfolio by taking the value of each of the securities and dividing it by the total value of the security.
Once the expected return of each security is known as well as the weight of each security has been determined, this person simply multiplies the expected return of each security by the weight of the same security as well as adds up the product of each security.
How to calculate expected portfolio return
Let’s calculate the expected return. To make it easier, let’s say that the portfolio contains three securities. The equation for this portfolio’s expected return is as follows:
Expected return=WA × RA + WB × RB
Where =Weight of security A
RA = Expected return of security A
WB= Weight of security B
RB=Expected return of security B
WC= Weight of security C
RC= Expected return of security C
Investors should not forget that the expected return is based on historical data. Hence, investors should take into account the likelihood that each security will achieve its historical return given the current investing environment. Some assets, like bonds, are more prone to match their historical returns. However, others like stocks may vary more widely from year to year.
The expected return and important details
Investors should keep in mind that the market is volatile as well as unpredictable. Since the market is unpredictable calculating the expected return of a security is more guesswork than definite. So it can create inaccuracy in the resultant expected return of the overall portfolio.
Expected returns do not provide a complete picture, so making investment decisions based on them alone can be dangerous. For example, expected returns do not include volatility into consideration. Securities that range from high gains to losses from year to year can have the same expected returns like the ones that stay in a lower range. Also, expected returns are backward-oriented, they do not factor in current market conditions. They do not cover political and economic climate, legal and regulatory changes as well as other elements.
In conclusion, to calculate a portfolio’s expected return, an investor needs to calculate the expected return of each of its holdings. Moreover, this investor has to calculate the overall weight of each holding. The basic expected return formula fills in multiplying each asset’s weight in the portfolio by its expected return. The next step is to add all those factors together.
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