probable return on investment the projected percentage return on an investment, based on the weighted probability of all possible rates of return.
It is calculated by the following formula:
where E[r] is the expected return, P(s) is the probability that the rate rs occurs, and rs is the return at s level.
The following example illustrates the principle that the formula expresses.
The current price of ABC Inc. stock is trading at $10. At the end of the year, ABC shares are projected to be traded:
25% higher if economic growth exceeds expectations-a probability of 30%;
12% higher if economic growth equals expectations-a probability of 50%;
5% lower if economic growth falls short of expectations-a probability of 20%.
To find the expected rate of return, simply multiply the percentages by their respective probabilities and add the results:
(30% × 25%) + (50% × 12%) + (25% × -5%) = 7.5 + 6 + -1.25 = 12.25% ERR
A second example:
if economic growth remains robust (a 20% probability), investments will return 25%;
if economic growth ebbs, but still performs adequately (a 40% probability), investments will return 15%;
if economic growth slows significantly (a 30% probability), investments will return 5%;
if the economy declines outright (a 10% probability), investments will return 0%.
(20% × 25%) + (40% × 15%) + (30% × 5%) + (10% × 0%) = 5% + 6% + 1.5% + 0% = 12.5% ERR
Related definitions of "expected return"
- Also called expected rate of return