How to calculate Expected Rate of Return(ERR)

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An investment’s “expected return” is the total money one can expect to lose or gain on an investment with a foreseeable rate of return. Basically, it lets one know whether the investment would be profitable providing enough money or it will be a loss, costing the investors’ money. By extension, it also tells one what kind of return you can expect when from a portfolio with a particular mix of investments.

Understanding the Limits of Expected Return

The expected rate of return is more of a closer guess than a firm prediction. Regardless of whether you calculate the expected return of an entire portfolio or an individual stock, the correctness of the formula depends on getting the assumptions right.

In case one has a portfolio, they will have to calculate each asset's expected to return to get the portfolio’s return. AQs is obvious, expecting future results will have inherent uncertainty. As an investor one must calculate it with an assumption that the asset’s growth and yield in the past will continue undisturbed into the future. If one’s stock returned good dividends in the past year, it will have to continue to pay those dividends in future years too. If it grew 15 % in the past year, it will grow by at least another 15% this year.

Although the assumptions are not completely speculative, neither are they completely reliable. While past performance can, sometimes, indicate future results, there is no such guarantee.

How to Calculate a Portfolio’s Expected Return

The expected return of a portfolio of assets is based on the rate of return of each singular asset, and each asset’s value in the portfolio.

  • Rate of Return – An asset’s rate of return computes how much money one, as an investor, would have made or lost over a specific period when they held the asset. For example, say one assumes an INR 1,000 investment in a stock over a one-year period after which they sold it. Between dividends bought and the sold, they would have made INR 200. The rate of return on this stock would be 0.20 percent.

  • Asset weight – The net percentage of the portfolio that any given asset makes up is known as the weight of the asset. One needs to calculate this by dividing the value of each chosen asset by the total value of the portfolio. For example, in case one’s portfolio is worth INR 50,000. A single asset in it is worth INR 18,000. This asset’s weight in the portfolio would be 36 percent.

Now, with the rate of return and asset weight in hand, one can calculate the expected rate of return. One just needs to multiply the expected rate of return for each asset by that asset’s weight. Then, add each of the results together. Written as a formula, we get −

$$\mathrm{Expected\:Rate\:of\:Return\:(ERR) = (𝑅_{1} × 𝑊_{1}) + (𝑅_{2} × 𝑊_{2}) + ⋯ + (𝑅_{n} × 𝑊_{n})}$$

Updated on 17-Sep-2021 08:48:26