What to Do
The formula to use to make an educated estimate of an investment’s potential return is:
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.
This can be more easily illustrated by considering the case of an investment in stock in J. Smith Inc., presently trading at $10. This stock is expected to be trading at $12.50, 25% higher, within a year if economic growth exceeds expectations—a probability of 30%; at $11.20, 12% higher, if economic growth equals expectations—a probability of 50%; and, at $9.50, 5% lower, if economic growth falls short of expectations—a probability of 20%.
The expected rate of return is found by multiplying the percentages by their respective probabilities and adding the results:
Alternatively, if economic growth remains stable (a 20% probability), investments will return 25%; if economic growth eases, but still performs satisfactorily (a 40% probability), investments will return 15%; if economic growth slows significantly (a 30 per cent probability), investments will return 5%; and, if the economy weakens (a 10% probability), there will be no return. Therefore:
What You Need to Know
These calculations will be invalid if the probability totals do not always equal 100%. They will also be invalid if negative numbers have not been included. A calculated expected rate of return is only as good as the scenarios considered. Wildly unrealistic scenarios will produce equally unrealistic results.
Where to Learn More
Web Site:
investopedia.com www.investopedia.com
