Calculating expected rate of return on investment

A rate of return can be said to be the gain or loss on an investment over a specific period of time which is expressed as a percentage of the cost of the investment. It can also be said to be the net amount of a discounted cash flow gotten on an investment.

A rate of return can be applied to any investment either of real estate, bond, fine art, stock as far as the asset was at one point acquired and at another point in the future produced cash flow. Investments are always assessed based on their past rates of return, which can be compared with other assets or properties of the same type to ascertain which investment is more lucrative.

EXPECTED RATE OF RETURN

Expected rate of return also known as expected return is the amount of gain or loss an investor foresees on an investment that has different known or expected return rates. It can also be said to be the rate of return anticipated on an asset or portfolio which depends on a specific asset pricing model over a period of time. The expected rate of return on a particular asset is the same with the sum of the possible rates of return which is multiplied by the probability of earnings on the returns. This is usually based on data acquired over time and cannot be 100% trusted. It is only but a tool used to ascertain whether or not an investment will have a positive or negative outcome.

CALCULATING EXPECTED RATE OF RETURN

This is calculated by estimating the possibility of a full range of returns with the possibilities summing to 100% i.e. multiplying the anticipated outcomes by the chances of them happening and then adding up the two results. Example:

If an investment has a 60% chance of gaining 20% and a 50% chance of losing 5%, the expected return therefore will be:

60% * 20% + 50% * -5% = 9.5%

Meaning that the expected return of this 9.5%

In other words, expected return corresponds with the addition of each possible rate of return multiplied by the corresponding probability. Let’s check this out using another example;

An investor opens a new business. All things being equal and the economy thrive well and people patronize this business, we can assume that the internal rate of return will be 25%. This corresponds to the annual expected profit in proportion to the investment made with a 70% probability of it occurring.

If things don’t go well then the internal rate of return might be 10% with a 10% chance of it happening.

If things turns out very badly with an economic recession then the internal rate of return would be -10% and a 20% possibility of happening.

The solution to this will be: 0.7 * 25 + 0.1 * 10 + 0.2 * (-10) = 16.5%

This means that in this case the expected rate of return is 16.5% per annum.

CONCLUSION

These projections are qualitative in nature, meaning that it is possible that different people using the same information will come up with different probability percentage with different rates of return.

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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