Intelligent investors know two crucial things. First, there is no completely foolproof way to predict the growth or decline of an investment. There are too many variables out of an investor's control and too many unpredictable factors to ever have a guaranteed gain. (In fact, if your financial advisor tries to make you such a promise, be suspicious.) Second, and perhaps paradoxically, anticipating performance is still critically important to making broad investments and helping others do the same. Financial wizards do this by calculating the expected rate of return on both individual assets and entire portfolios. As an investor, you should understand what an expected rate of return is and why it's essential, in addition to how to calculate a simple one for yourself.
What Is an Expected Rate of Return?
If you know an investment's historical rates of return, you can use a formula to make an educated guess on probable future returns. The expected rate of return is the anticipated profit or loss that an investor anticipates on an investment, explains the team at Corporate Finance Institute. It's what many investors use to determine whether an investment is safe or sound before buying into it. It is sometimes abbreviated as RoR, or rate of return.
Video of the Day
Essentially, investors use a precise formula to insert known numbers. These numbers include potential outcomes and odds. You can calculate expected rates of return for entire portfolios. To do this, you would calculate each rate of return and then average them all together. You would then refer to the individual rates of return as they occur in real-time to gauge how accurate your estimates were and make adjustments to the portfolio accordingly.
How to Calculate an Expected Rate of Return
To calculate your expected rate of return, you'll need to locate a few figures relevant to your investments. This is what the formula for the expected rate of return look likes: Expected Return = (Return A x Probability A) + (Return B x Probability B), explains the team at SoFi. If you're using percentages, the total for the probabilities should probably add up to 100 percent, or nearly 100 percent. For instance, if there's an equal chance that the investment will return either 20 or 30 percent, then you will set up your equation like this:
Expected Return = (20 percent x 50 percent) + (30 percent x 50 percent)
Expected Return = (10 percent) + (15 percent) = 25 percent
Expected Return =25%
That rate of return means that if you make a $100 investment, you can expect to gain back $125, including the 25 percent return.
If you're calculating the expected rate of return for a more complex investment or an entire portfolio, the math will be more complicated and time-consuming. In addition, the more variables you include, the greater the chance that your numbers might be off, but also closer to actual figures (again, paradoxically). The surest way to calculate the expected rate of return on a portfolio is to do so for each investment and then average them together. Still, you can also use a single equation to determine the overall rate, though it will be much more of an estimate.
Knowing the Expected Rate of Return Matters
To make wise investments, you have to be able to have some idea of their projected outcome. That way, before you invest, you have an idea of how much money you may or may not make and how long you need to hold onto the investment to get the most out of it.
For example, an expected return can also help you see when the investment has probably reached its peak. Unless something changes impacting expectations, once that $100 investment hits $125, it's likely time to sell because there isn't a strong possibility of it climbing much higher.
Consider also: Difference Between Expected Rate of Return vs. Rate of Return