Financial investments are an integral part of every individual. Different kind of investment is done all over the world to get maximum returns and profits. When an investor, invest capital the foremost thing they want to know is how much money they will expect to earn in the future based on the expected rate of return. This return is usually from holding the security for a certain period of time. We commonly call the return as result of holding for a period of time as holding period return. Is this investment would be favorable for them or not?
To figure out how much return will be received through the specific investment a financial technique is used know as Expected Rate of Return (RoR). The rate of return is the money a person is expecting to obtain after doing an investment. This article would let you know in detail how RoR works for the capitalists.
Table of contents
What is the Expected Rate of Return?
Expected Rate of Return (RoR) is also known as “Expected Gain”. It is the return (profit or loss) that an investor is expecting to receive during a monthly, quarterly, or yearly set of periods. The investment return value is an unknown variable that could have distinct values depending upon different possibilities. In simpler words, RoR is the estimation of the value that capitalists would earn in the future on some financial investment.
How Expected Rate of Return Be Used?
The expected rate of return is the significant method used in the financial industry in order to decide whether a certain investment has a favorable or unfavorable average net result. It is generally based on historical data. Hence, there is no assurance of what would be RoR value in the future. Nevertheless, an investor can still estimate reasonable outcomes to make better investment decisions.
Why is the Expected Rate of Return Important?
Usually, we consider investments a bit risky but with help of RoR, the investors and companies can easily determine the risk factors associated with a required rate of return. The expected rate of return is a beneficial tool for investing parties who plans to establish out model portfolio.
In the stock market, it is difficult to figure out the accurate expected gain, but by analyzing the stock’s history and overall market trends you can calculate the approximate return value over a period of time. Prior determination of profit or loss enables investors to make the best financial plans.
How to calculate the expected rate of return?
RoR is a vital part of both financial theory and business operations which involves popular models such as the black-Scholes option pricing model & modern portfolio theory (MPT). It is calculated by both the probability approach and the historical return approach.
The expected rate of return is measured by multiplying possible outcomes with the probability of their occurrence and then adding up these outcomes. The total is determined as the expected value (EV) of a specific investment considering its expected profit/return in contrasting scenarios; the expected rate of return formula is as;
Expected Return (ER) = Sum (Returni x Probabilityi)
ER= R1P1+ R2P2 + R3P3 +…..+RnPn
In this equation R is the return/gain expected in a certain scenario, P represents the probability or chances of the return being attained in the scenario, and where n is the number of scenarios. This probability distribution could be discrete or continuous. A discrete variable can take only specific value whereas; in continuous distribution, the variable could be any within the given range.
The return value could be any random variable containing any value according to the given range. Its estimation is based on historical data, which makes it difficult to determine an accurate rate of return. The RoR is the calculation of probabilities planned to forecast the possibility that a specific investment would produce a positive gain, and what will be the expected return.
Example and Calculation
For instance, an investor is planning to invest in two securities. The percentage of gain in Security X has six possible outcomes and the percentage of gain in security Y has four possible outcomes;
|Rate of Return||-7%||-3%||5%||8%||12%||15%|
|Rate of Return||-15%||9%||10%||16%|
Let’s insert values in the equation:
Rate of return of security X = 0.05(-7%) + 0.10(-3%) + 0.30(5%) + 0.15(8%) + 0.25(12%) + 0.35(15) = 7.15%
Rate of return of security Y = 0.20(-15%) + 0.40(9%) + 0.45(10%) + 0.25(16%) = 9.1%
Analyzing the outcomes, the security Y should be preferred as it has a greater rate of return than security X. Hence, it would be more beneficial for an investor.
A portfolio is a combination of multiple investments. Let’s consider a portfolio involve three securities.
|Security X||Security Y||Security 3|
|Rate of Return||9.1%||4.5%||6.7%|
The RoR of Portfolio = 0.15(9.1%) + 0.3(4.5%) + 0.45(6.7%) = 5.73%
Advantage of Expected Rate of Return
The following merits are to be noted while you plan using the RoR method:
- Return on investment assists in investment projects by providing a comparison between risk vs probable return.
- It gives an idea of how much investors will reasonably make from a certain investment.
- RoR allows individuals and companies to make long-term investment plans by estimating the probability of gain.
Limitation of Expected Rate of Return
The following demerits are to be noted while you plan using the RoR method:
- In investment projects, the rate of return procedure utilizes accounting profits; it does not use cash inflows.
- The time value of money is ignored in this method which is an essential element in money expenditure decisions.
- It only determines the expected gain not the duration of the investment project.
- Due to market or economic fluctuation return is not guaranteed. The investor can also face a loss in the investment.
Expected Rate of Return (RoR) is the widely used concept in financing. It is the percentage of anticipated return that the investor gets after a certain time. It suggests whether the investing amount will bring positive or negative return outcomes.