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What Is Expected Rate of Return?

G. Wiesen
G. Wiesen

Expected rate of return is a value used in economic and financial discussions of investments to indicate the statistically likely return rate on an investment. This is determined by utilizing a number of possible rates of return, along with the likelihood that each of those is going to occur. These numbers are then averaged to determine the rate most likely to occur for that particular investment. Expected rate of return should not be confused with guaranteed rate of return, which is not based on averaging different possibilities and is instead guaranteed for a particular investment.

An expected rate of return is often provided for investments in the stock market and other venues in which the return rate cannot be guaranteed. There is always some degree of risk attached to making this kind of investment, since it is only an estimate based on the most likely scenario. Unexpected and unforeseen events can drastically impact this estimation and lead to unpredictable gains or losses. When someone conveys the likely rate of return on an investment as a range between two values, then he or she can typically provide an expected rate of return.

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Calculating this for a particular investment is fairly simple, though it requires a good deal of information about the investment. Someone needs to know the most likely return rates, as well as the statistical probabilities of those returns occurring, which can require a combination of research and prediction. These numbers are then averaged together to generate a rate that is the most likely to occur.

A particular stock investment, for example, might have a 10% chance of losing 10%, a 30% chance of increasing by 10%, and a 60% chance of increasing by 20%. The chance and each potential return are multiplied together, meaning 0.1 and -0.1 are multiplied together for the first possibility, 0.3 and 0.1 for the second, and 0.6 and 0.2 are multiplied together for the last; which produces -0.01, 0.03, and 0.12. These values are then added together for 0.14 or 14%. This means the expected return rate for this investment is a 14% gain.

The expected return rate should not be confused with a guaranteed rate of return. Investments with a guaranteed rate have a predicted rate that will be paid, such as a bond or similar investment that has a preset rate for a certain period of time. This type of return is financially guaranteed by the person or agency requesting the investment.

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