THE BEECHMONT CREST ONLINE GUIDE TO STOCKS AND INVESTING
Calculating the Expected Rate of Return of an Investment
Some investments, like bank certificates of deposit, have guaranteed rates of return. Investments like stocks are a bit more complicated. If you ask an investor how much she expects to earn on the stock of a pharmaceutical company or high-tech firm, she will like answer in terms of a range: “Oh, I expect to earn somewhere between 10 and 20 percent on these shares.”
Whenever an investor describes future returns in terms of a range like this, you can be sure that there is risk involved. In the investment context, risk is the uncertainty that a given investment will earn its anticipated rate of return.
But how does an investor formally calculate risk? One method is known as the expected rate of return. To calculate the expected rate of return, an investor first enumerates all the possible rates of return that an investment could have. For simplicity’s sake, let’s imagine an investment with four possible rates of return:
a.) -10%
b.) -5%
c.) 10%
d.) 20%
The first two rates of return (a. and b.) indicate a loss. The second two (c. and d.) each indicate a gain.
The next step is to assign probabilities to each rate of return
a.) -.10 (.10)
b.) -.05 (.10)
c.) .10 (.50)
d.) .20 (.30)
The above part of the process entails some subjectivity, but it is possible to make some educated guesses based on past performance of the investment itself, and the demonstrated performance of similar investments. General market and economic factors should also be taken into account.
Then determine the expected rate of return (ERR) using the somewhat formidable-looking equation below:
n
ERR = Σ (Possible Return x Probability)
i = 1
ERR = [ (-.10) (.10) + (-.05) (.10) + (.10) (.50) + (.20) (.30)]
= .095
The expected rate of return is .095. This means that the investor can expect a 9.5% return on her investment.
