What is the Expected Rate of Return?

The expected rate of return is the return on investment that an investor anticipates receiving. It is calculated by estimating the probability of a full range of returns on an investment, with the probabilities summing to 100%.

Since the probabilities used in these projections are qualitative in nature, it is quite possible that two people using the same information will come up with different probability percentages, and therefore different rates of return. This is especially the case when the individuals use historical information as the basis for their projections; historical results do not necessarily translate into future results. When developing a range of possible outcomes for a prospective investment, one should always examine the risk profile of the underlying project.

Problems with the Expected Rate of Return

There are several concerns with using the expected rate of return concept, which are as follows:

Usually based on historical data. Most people derive their estimates of probabilities of return based on historical information. This means that they are giving less credence (if any) to events that have not occurred in the past, but which might occur in the future.
Does not account for risk. The probability of return concept does not address the risk undertaken in order to achieve that probability level. You might pursue a highly risky strategy where the cost of failure is a complete loss, in order to arrive at a modest probability of achieving a high rate of return.

Example of the Expected Rate of Return

An investor is contemplating making a risky $100,000 investment, where there is a 25% chance of receiving no return at all. There is also a 50% probability of generating a $10,000 return, and a 25% chance that the investment will create a $50,000 return. Based on this information, the expected rate of return is:

$0 return x 25% = $0 return

$10,000 return x 50% = $5,000

$50,000 return x 25% = $12,500

The investor then sums these projections to arrive at an expected rate of return of $17,500, or 17.5%, which is calculated as:

$17,500 sum of returns ÷ $100,000 investment = 17.5% expected rate of return