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How is the expected return on a portfolio calculated?
Rather than taking each rate of return and multiplying them with the weight to get the total weight of each asset, there is a simple formula to calculate the expected rate of return. The expected rate of return of a portfolio or simply the return of a portfolio is the given weighted average of the expected returns on the assets.
Example
Let's take an example of a two-asset portfolio and see how to calculate its expected return. Let’s assume an investor has invested 50% of his investment in X and 50% in Y.
$$\mathrm{ERR\:of\:Portfolio = (Weight\:of\:Security\:X × 0.5) + (Weight\:of \:Security\:Y × 0.5)}$$
Note that the added sum of the given weightage must be equal to 1 because the two weights cumulatively make 100% of the weightage. This is applicable to more than two asset cases too.
Given the return rates of assets, the total return from the portfolio depends on the weight of the assets. In fact, the expected rate of return is proportionate to the weights of the assets. One can easily change their type of investment by changing the weights of assets. For example, if X is making a profit and is expected to do so in the future, one can invest more money in X than Y.
Importance of Expected Rate of Return
In most cases, the expected rate of return gives an investor the idea of whether investing in a particular asset will produce a gain or a loss. Depending on historical data, investors can shape their future plans of action. The expected return doesn’t guarantee a specific outcome but can be helpful in getting an idea about the whole investment scenario.
By determining the expected return on a portfolio, investors can determine the diversification of the portfolio as well. As they need to analyze the weighted averages of each asset in the portfolio, they get a fair idea of the diversification of the assets. Calculating the return also lets investors determine the probable profit and risk of an investment.
Drawbacks
The biggest drawback associated with the calculation of the expected return is its unpredictability. As the market conditions are dynamic and changes occur very frequently, no investor can claim that their chosen plans of action will be 100% rewarding. That is why it may lead to an inaccurate decision.
Also, expected returns do not consider the volatility of the prices in the market. So, no business decision should be made depending on the expected rate of return alone. The more one takes the drawbacks into consideration, the more will be the profitability of an investment portfolio.
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