When it comes to making financial investments, investors want to know how much money they will make off the principal they invested. That might seem like a tall order: investors are somewhat at the mercy of the marketplace. However, by calculating the different possible outcomes of a given investment, you can derive an "expected rate of return." The math is fairly straightforward, and it will give you a window into the financial future of the investment in question.
Understand the expected rate of return formula. Like many formulas, the expected rate of return formula requires a few "givens" in order to solve for the answer. The "givens" in this formula are the probabilities of different outcomes and what those outcomes will return. The formula is the following.
(Probability of Outcome x Rate of Outcome) + (Probability of Outcome x Rate of Outcome) = Expected Rate of Return
In the equation, the sum of all the Probability of Outcome numbers must equal 1. So if there are four possible outcomes, the total of four probabilities must equal 1, or, put another way, they must total 100 percent.
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Plug the numbers into the equation. For example, if an investment had a 30 percent chance of returning 20 percent profits, a 50 percent chance of returning 10 percent profits and a 20 percent chance of returning 5 percent, the equation would read as follows:
(.30 x .20) + (.50 x .10) + (.20 x .05) = Expected Rate of Return
Calculate each piece of the expected rate of return equation. The example would calculate as the following:
.06 + .05 + .01 = .12
According to the calculation, the expected rate of return is 12 percent.