Expected Rate of Return Calculator
Estimate your stock's performance based on probability scenarios.
Scenario 1: Bull Market (Optimistic)
Scenario 2: Base Case (Likely)
Scenario 3: Bear Market (Pessimistic)
Weighted Expected Rate of Return:
How to Calculate the Expected Rate of Return of a Stock
The Expected Rate of Return is a fundamental concept in finance used to estimate the average profit or loss an investor anticipates on an investment over a specific period. It is not a guarantee of performance but rather a probability-weighted average of all possible outcomes.
The Weighted Average Formula
To calculate the expected return using different market scenarios, you use the following formula:
E(R) = (P1 × R1) + (P2 × R2) + … + (Pn × Rn)
Where:
- P: The probability of a specific scenario occurring (expressed as a decimal).
- R: The return associated with that scenario.
Step-by-Step Example
Imagine you are analyzing a tech stock. You identify three possible market conditions for the next year:
- Bull Market: 25% chance (0.25) of a 20% return.
- Steady Market: 50% chance (0.50) of an 8% return.
- Bear Market: 25% chance (0.25) of a -10% return.
The calculation would look like this:
Expected Return = (0.25 × 20) + (0.50 × 8) + (0.25 × -10)
Expected Return = 5 + 4 – 2.5 = 6.5%
Why Expected Return Matters
Understanding the expected rate of return allows investors to compare different assets on an apples-to-apples basis. While a stock might offer a massive 50% return in a "best-case" scenario, if the probability of that scenario is only 5%, the weighted expected return might be lower than a "boring" index fund with a high probability of moderate gains.
Key Factors to Consider
- Probability Estimation: These are subjective. They are often based on historical data, economic forecasts, and industry analysis.
- Standard Deviation: The expected return doesn't tell you about volatility. Two stocks could have an expected return of 7%, but one might fluctuate wildly (high risk) while the other remains stable (low risk).
- Dividends: When calculating returns, always remember to include both price appreciation and expected dividend yields.