The expected rate of return on a portfolio is the percentage by which the value of a portfolio is expected to grow over the course of one year. A portfolio's expected rate of return may differ from the outcome at the end of one year, called the actual rate of return. A portfolio's expected rate of return is calculated based on the probability of a portfolio's potential returns.
An investment portfolio is a pool of market-traded assets owned by an entity or an individual. Portfolios are primarily made up of stocks and bonds, but may also contain precious metals, real estate and a variety of derivatives. Portfolios are assembled based on the understanding that by investing in different assets, or diversifying, investors can reduce the risk of loss. To this extent, investors can allocate assets in their portfolios according to their risk preferences.
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Portfolios and Risk
The risk that a portfolio will lose value can never be completely eliminated. Levels of such risk correlate directly with the potential level of return. For instance, a portfolio exposed to a high level of risk is capable to yielding higher potential returns than a portfolio exposed a low level of risk. For this reason, high-risk portfolios are made up largely of stocks, or equity. By contrast, low-risk portfolios mainly comprise fixed-come items, such as bonds and short-term (less than one year) money market securities.
Expected Rate of Return
A portfolio's expected rate of return is an average which reflects the historical risk and return of its component assets. For this reason, the expected rate of return is solely a conjecture for the sake of financial planning and is not guaranteed. All things being equal, an investor can expect that the actual rate of return will fall in the vicinity of this figure.
A given portfolio generally has several possible outcomes as far as its percentage return. Using historical data for the securities in a portfolio, it is possible to assign a percentage probability to a handful of outcomes. The expected rate of return is calculated by first multiplying each possible return by its assigned probability and then adding the products together.
Suppose a portfolio is determined to have three possible returns: 40 percent, 20 percent and 5 percent. There is a 10 percent probability of a 40 percent return, a 45 percent probability of a 20 percent return and a 70 percent probability of a 5 percent return. The expected return would be 16.5 percent, calculated as follows:
(0.1 times 0.4) plus (0.45 times 0.2) plus (0.7 x 0.05) equals 0.04 plus 0.09 plus 0.035 equals 0.165 or 16.5 percent
A portfolio's actual return is the percentage by which its total value rose or fell when measured at the end of one year. Together with the initial expected rate of return, a portfolio's actual return can be used to better understand why a portfolio performed better or worse than predicted.