Expected Rate of Return
What is the Expected Rate of Return?
The expected rate of return is the expected return on a security, usually a stock, using the probability of an occurrence and the return of the action. Sounds pretty screwed up. Well it is. In actual English or understandable terms, check out the picture below.
Expected Rate of Return Structure.
In the first column, there is no label on top, but the row titles are: Exceptional return, normal return, below average return. On the column to the right, I have it labeled probability. Next to that, I have it labeled rate. And next to that, I have it labeled weighted average.
Expected Rate of Return Probability
So, with the structure explain, what goes below the probability title would be the probability is of an action happening. For example, there is a 30% probability of an exceptional return, a 50% probability of a normal return and a 20% probability of a below average return.
Expected Rate of Return Interest Earned.
Next to the probability column, is the interest rate column. In this column, I put the interest rates that are expected if this action occurs. To illustrate, if the normal return happens, then the investor would get a 6% return. Keep in mind, the probability of this happening is 50%. To keep going with this, the interest rate that an investor would receive for an exceptional return would be 15%. As for a below average return, this interest rate would be -20%.
Weighted Average for Expected Return
The second to final steps in this process is to calculate the weighted average column. In this column, we simply multiply the probability by the interest rate. For the exceptional return, we would multiply 30% by 15%. This would give us a weighted average of 4.5%. We would continue this practice for normal returns as well as below average returns.
Final Step for Calculating Expected Return.
And finally, the final step is to add up all the weighted average that we calculated. This gives us our expected rate of return.
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