Expected return is the average value investors expect an asset to gain or lose over a given period, calculated by weighting all possible financial outcomes by their probability. Actual returns may differ, and abnormal returns can occur due to mergers, interest rate changes, or lawsuits. Investors use various methods to predict expected returns, but risk-free assets like bonds can negatively affect calculations. The equity premium puzzle remains unsolved.
An expected return is the value that investors expect an asset to gain or lose on average over a given period of time. More precisely, it is the sum of all possible financial outcomes of an asset that are weighted by the probability that the outcome will occur. Easily calculated using a tree diagram, if an asset has a 70 percent chance of earning 6 percent and a 30 percent chance of earning 9 percent in a year, then the asset’s expected return is calculated as 6.9 percent. Interest, dividends, and capital gains and losses on assets affect your expected returns. Also known as the mean return, it is investors’ best predictor of future market behavior.
Actual vs. Expected Returns
Unlike an expected return, an actual return is the reported amount that an asset gained or lost during a given period. A total return is the actual return on an asset over an investment horizon, including reinvestment fees. It is highly unlikely that the actual return on an asset will be exactly the same as the expected return, so an asset is considered “working” if its actual and expected returns are close enough. If an asset has underperformed or significantly exceeded its expected return, then it is called an abnormal return, which could occur due to mergers, interest rate changes, or lawsuits, all of which affect the particular asset rather than the market at hand. its set.
prediction methods
To detect and exploit abnormal returns, investors rely on a variety of methods to accurately predict an asset’s expected return. In addition to the tree diagram calculation mentioned above, another simple method is to take the historical average of past annual returns. The historical average is not a bad estimate if a company has a long history, has accurate historical data, and has made few changes to its structure, policies, and strategies. On the other hand, the calculation does not take into account volatility, which is a measure of the price variation of investment options from one year to the next and is therefore a rather primitive estimate.
Risk Free Assets
Some economists have noted that risk-free assets like bonds have unexplained lower long-term total returns than more volatile assets like stocks. As a result, risk-free assets can negatively affect the calculation of an expected return. Economists Edward C. Prescott and Rajnish Mehra called this phenomenon “the equity premium puzzle,” which economists have struggled to understand. The equity premium is the excess return that remains when the returns on risk-free assets are subtracted from the expected market return. Modern economic models, such as the Capital Asset Pricing Model (CAPM), attempt to solve the riddle of the capital premium by estimating the expected return on risk-free assets differently from risky assets. The model takes into account the volatility of risky assets and their sensitivity to changes in the market.
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