A Comprehensive Guide to Calculating Expected Portfolio Returns (2024)

Every investor, from Wall Street veterans to those just starting their financial journey, wants to know, "How will my portfolio perform?" Whether planning for retirement, saving for a significant purchase, or simply aiming to grow your wealth, understanding how expected portfolio returns are calculated is crucial in helping you plan for your future.

"Calculating expected returns and the standard deviation can be a useful exercise so that the investor knows whether their portfolio is on or near the efficient frontier," said David Tenerelli, a certified financial planner at Strategic Financial Planning in Plano, Texas. The efficient frontier is a plot of potential returns on a chart that tells you where the best mix of risk and returns is for your goals and risk tolerance. This gives you the answer, he said, to the question, "Are you being compensated in expected return for the level of risk that your portfolio is exposed to?"

Calculating expected returns isn't just about predicting gains; it's also about making more informed investment decisions, managing risk, and aligning your assets with your financial goals.

In this comprehensive guide, we'll break down the concept of expected portfolio return into digestible components, using simpler methods for calculating it while understanding the principal factors that influence the results. While you may ultimately rely on financial algorithms on an investing platform for precise calculations, understanding the underlying principles will give you valuable insights into constructing and managing your portfolio, equipping you with the knowledge to make more confident investment decisions.

Understanding Expected Portfolio Return

Investment portfolios are built around their overall expected returns. This is the average outcome you anticipate from your investments over time. The expected return isn't a guarantee or a precise prediction but an educated, data-driven estimate.

We make these kinds of risk-reward assessments all the time without realizing it. For example, when creating a weekly meal plan, many are essentially building a "portfolio" of foods to meet their nutritional needs, preferences, and dietary restrictions:

• Fruits and vegetables (low risk, steady health benefits)
• Lean proteins (moderate risk, high nutritional value)
• Whole grains (low risk, steady energy)
• Occasional treats (high risk in terms of health, high reward in enjoyment)

This balance of different food groups with varying nutritional profiles and costs is much like balancing different asset classes in a financial portfolio:

• Bonds: The fruits and vegetables of investments (low risk, steady returns)
• Blue chip stocks: The lean proteins of Wall Street (moderate risk, typically good value in the long run)
• Index funds: Your portfolio's hearty grains (moderate risk, broad market exposure)
• Growth stocks: The desserts of the investment world that most will need to keep relatively limited (higher risk, potential for higher rewards)

Just as a balanced diet supports—but doesn't guarantee—overall health, a well-diversified investment portfolio aims to optimize returns while managing risk. Understanding expected returns is vital for several reasons:

• Risk assessment: It helps you gauge the potential rewards relative to the risk of an investment.
• Portfolio construction: Expected returns of different assets guide how to best allocate your capital.
• Goal setting: It allows you to better align your investment strategies with your financial objectives.
• Performance evaluation: Expected return provides a benchmark against which actual performance can be measured.

Calculating Expected Portfolio Return

Computing the expected return of a portfolio involves several steps:

1. Identify the different parts of your portfolio. List all the individual assets or investments you own.
2. Determine expected returns for each asset. The expected return of each asset can be estimated based on historical data, financial models, or analyst forecasts.
3. Calculate the portfolio weights. Determine what percentage of your total portfolio value each asset represents.
4. Multiply individual returns by their weight. For each asset, multiply its expected return by its weight in the portfolio.
5. Add up the weighted returns: Add up all the weighted returns calculated in step 4.

The formula for expected portfolio return is as follows:

• Expected Return of the Portfolio E(Rp) = Σ (Weight of each asset × Expected Return of each asset)

Let's suppose you have a portfolio with three assets:

• Asset A: Its expected return is 8%, and 50% of the portfolio is invested in it.
• Asset B: Its expected return is 12%, and 30% of the portfolio is invested in it.
• Asset C: Its expected return is 6%, and 20% of the portfolio is invested in it.

Compute the portfolio's expected return as follows:

1. Calculate the weighted expected returns.

• Asset A: 50% × 8% = 4%
• Asset B: 30% × 12% = 3.6%
• Asset C: 20% × 6% = 1.2%

2. Sum up the weighted expected returns.

• The expected return of the portfolio = 4% + 3.6% + 1.2%

Adding these together, the expected return of the portfolio is 8.8%.

Calculating Expected Returns of Individual Securities

Above, we provided the expected returns for each asset. The expected return is the average return you can anticipate from holding a security over a specific period—a prediction of its potential earnings.

For example, suppose you buy a stock for $100 and expect its value to increase by 10% over the next year, anticipating it will be worth $110 at year-end. Your expected return is $10, or 10% of your initial investment.

Most assets are often more complex than this. The capital asset pricing model (CAPM) is a widely used method for calculating expected returns, particularly for stocks. It considers various factors influencing a security's potential return and is relatively easy to use since most financial websites provide its components.

The CAPM formula for the expected return of a stock is as follows:

• Expected Return = Risk-Free Rate (R_f) + (Beta (β) × Equity Risk Premium (ERP))

Given the Greek letters and acronyms, this looks more difficult than it is. Here's a breakdown of each part of the equation:

• R_f: Typically used is the yield on 10-year U.S. Treasury notes. It's the return you can expect with virtually no risk, representing what you would get at a minimum and with no risk.
• β: Measures the stock's volatility relative to the market. A beta of 1.0 means the security moves in line with the market. If it's higher than 1.0, it's more volatile or riskier than the market, and if it's less than 1.0, it's less so. Most financial platforms have this for different stocks and funds.
• ERP: The added returns investors expect from the stock market over risk-free securities. This is calculated by taking the market return (R_m) and subtracting the R_f; it's the difference between what you'd expect from a stock minus what you'd get from a government bond.

Example: Home Depot Expected Returns

Suppose in August 2024, we wish to calculate the expected annual return for Home Depot (HD). You can do so with data easily found on Investopedia, TradingView, or another respected financial platform:

• The 10-year Treasury yield. This is R_f, which equals 3.75%.
• Home Depot's five-year beta (β) is listed as 0.99.
• We'll use the for the market return, which is about 10.25%.
  

Step 1: Calculate the ERP

• ERP = R_m - R_f = 10.25% - 3.75% = 6.50%

Step 2: Apply the CAPM formula

• Expected Return = R_f + (β × ERP)
• Expected Return = 3.75% + (0.99 × 6.50%) = 10.19%

Interpreting the Results

The expected return for Home Depot stock is thus 9.94% per year. This leads us to several points:

1. With a beta of 0.99, HD's expected return closely aligns with the overall market return, suggesting a performance similar to that of the broader market.
2. The difference between the expected return (10.19%) and the risk-free rate (3.75%) is the risk premium for holding HD stock.
3. This calculation assumes that past relationships between the stock, the market, and the risk-free rate will hold in the future, which isn't always the case as the market changes.
4. You should compare these figures against other stocks you're considering purchasing for your portfolio.
   

Calculating the Expected Returns for Bonds

While stocks often grab headlines, bonds play a crucial role in many investment portfolios. Computing the expected return of individual bonds differs from stocks but is equally important for informed investment decisions. The expected return of a bond is the total return from both interest payments and any change in the bond's price.

Suppose a bond has a coupon rate of 5% and a yield to maturity of 6%. The coupon rate is a fixed set of payments. Meanwhile, the yield to maturity measures the overall return, considering both the coupon payments and the bond's price change over time. So, for a bond with a coupon rate of 5% and a yield to maturity of 6%, the expected return is the yield to maturity itself, which is 6%. This assumes that you'll hold the bond until maturity and reinvest all coupon payments at the exact yield to maturity.

Factors Influencing Expected Returns

The expected return of a security is influenced by factors that range from broad economic conditions to company-specific attributes, creating a multifaceted landscape that investors must navigate. Generally, higher-risk investments are expected to yield greater returns to compensate for the added uncertainty.

Company-specific factors: Strong earnings growth, creative products, or increased market share can boost expected returns. Company-specific factors are internal characteristics and conditions unique to a firm that can significantly influence its financial performance and stock price. These are distinct from broader market or industry trends and include both quantitative (financial metrics such as earnings per share, revenue growth, and market share) and qualitative (management effectiveness, competitive position, etc.) elements.

Strong earnings growth or market-leading products can lead to higher expected returns. Tesla's (TSLA) stock price surged significantly in 2020 and 2021 because of strong sales growth, its electric vehicle technology, and positive market sentiment about its products. Likewise, in the early 2000s, Apple Inc.'s (AAPL) introduction of the iPod and, later, the iPhone significantly boosted its expected returns; the company's stock price increased significantly over time as investors anticipated future growth.

Dividends: The yields from dividends contribute to total return expectations, especially for income-focused investors. Dividends represent a part of a company's earnings returned to shareholders. A consistent or rising dividend yield is often seen as a sign of financial health and enhances expected returns.

Coca-Cola Co. (KO),for example, has a long history of paying dividends, which has contributed to its stock's expected return. Procter & Gamble (PG) also has a long history of paying increasing dividends, making it a favorite among income-focused investors. Investors view such companies as lower risk, often leading to higher valuations and expected returns compared with non-dividend-paying stocks.

Global events: From geopolitical tensions to pandemics, these can dramatically shift return expectations across sectors and asset classes. These events often lead to rapid reassessments of risk and potential rewards.

Inflation: This erodes the purchasing power of future cash flows, prompting investors to demand higher nominal returns to maintain real wealth. This is particularly relevant for fixed-income securities and long-term investments.

Market conditions: These play a crucial role in shaping expected returns. Economic indicators—such as gross domestic product growth, the unemployment rate, and consumer confidence—influence investor sentiment and expectations for returns. For instance, when the economy is expanding, the expected returns on equities tend to rise as investors anticipate stronger corporate performance.

Market sentiment: Driven by investor psychology, this can cause significant shifts in the price of stocks and other assets and thus affect your expected returns. Periods of excessive optimism or pessimism can lead to mispricing and subsequent corrections, as demonstrated by historical events like the dot-com bubble or later bear markets.

U.S. Federal Reserve interest rates: These have a profound effect on expected returns across various asset classes. When rates rise, bonds may become more attractive, potentially lowering expected returns on stocks as investors shift their allocations. Conversely, lower rates can drive investors toward riskier assets in search of higher yields.

Historical Performance and Expected Portfolio Returns

Expected portfolio returns are estimates based, in part, on historical data and assumptions. Actual results can vary.

Historical data provides valuable insights into the expected returns across different asset classes. Over the long term, stocks have consistently outperformed bonds, reflecting the higher risk associated with equity investments. For example, the has delivered an average annual return of about 8.4% since 1928, higher than the typical yields of government bonds, as we can see below:

In addition to the differences in expected returns between stocks and other assets, there is a range of results within the market for stocks. Technology companies, which account for a good proportion of those listed on the Nasdaq, often have higher volatility and risk compared with more stable sectors like utilities. This higher risk often comes with the potential for greater returns. A striking example of this occurred during the COVID-19 pandemic:

1. Tech stocks: Zoom Video Communications Inc. (ZM) saw its stock price soar more than 740% in 2020, as many workers and students moved online and others used it to keep in touch with family and friends in lockdown. This dramatic rise reflected high expected returns because of the sudden surge in demand for remote communication tools.
2. Utility stocks: In contrast, utility companies like Duke Energy Corporation (DUK) had relatively stable stock prices with lower expected returns. This stability is characteristic of the utility sector, which is known for consistent but modest growth.

These examples illustrate how different sectors can have varying risk profiles and expected returns, often influenced by broader market conditions and events. Investors must balance their portfolios according to their risk tolerance and return expectations, understanding that higher potential returns often come with increased volatility and risk.

Calculating the Weight of Each Security in a Portfolio

Once you've found the expected returns for the securities in your portfolio, you need to turn to its weight in the context of the total value of your holdings. The weight of a security is calculated by dividing the value of that security by the total value of the portfolio:

Weight of a Security = (Value of Security / Total Portfolio Value) x 100.

Let's look at an example. Suppose you have a portfolio with the following securities:

• Stock A: 100 shares, trading at $50 each
• Stock B: 200 shares, trading at $30 each
• Bond C: 10 bonds with a face value of $100 each

First, you'll determine the value of each security:

• Stock A: 100shares x $50/share = $5,000
• Stock B: 200shares x $30/share= $6,000
• Stock C: 10bonds×$100/bond= $1,000

Then, you calculate the total portfolio value:

• TotalPortfolioValue= $5,000 + $6,000 + $1,000 = $12,000.

Lastly, you compute the weight of each security (see the chart below):

• Weight of Stock A: $5,000/$12,000 x 100 = 41.67%
• Weight of Stock B: $6,000/$12,000 x 100 = 50%
• Weight of Stock C: $1,000/12,000 x 100 = 8.33%

Limitations of Expected Portfolio Returns

Rather than a single fixed value, the expected return of a portfolio is best understood as a probability distribution of possible outcomes. This distribution is shaped by the individual returns of each asset, their weights in the portfolio, and the correlations between assets. Investors and analysts often use statistical measures like standard deviation to quantify the spread of this distribution, providing insights into the range of potential returns. More sophisticated models employ Monte Carlo simulations to generate thousands of possible outcomes for the assets in your portfolio, each with its probability.

This probabilistic approach to expected returns allows investors to better understand the risk-reward trade-off of their portfolio, helping them make more informed decisions about asset allocation and risk management. By considering the average expected return and the likelihood of various outcomes, they can align their portfolio strategy with their risk tolerance and financial goals. The good news is that almost any financial advisor and many investing platforms can do this math for you.

While expected return calculations provide valuable insights, it's important to understand their limitations:

1. Assumption of a normal distribution: Many models assume asset returns follow a normal distribution (the bell curve of statistics). However, financial markets often exhibit abnormal behavior, characterized by "fat tails" (more frequent extreme events) and skewness. This can lead to underestimating the likelihood of significant market changes.
2. Reliance on historical data: Expected returns are typically calculated using historical data, implicitly assuming past performance indicates future results. However, market conditions, the broader economic context, and investor sentiment change dramatically over time rendering historical patterns less relevant, if not wholly so.
3. Focus on average returns: By concentrating on average outcomes, expected return calculations may underemphasize the impact of extreme or "black swan" events. These rare but significant events can have a disproportionate effect on portfolio performance.
4. Time horizon considerations: The typical expected return calculations might not account for your investing time horizon. Investors with different time frames often have distinct risk tolerances and return expectations, which aren't captured in a single expected return figure.

Additional Metrics

When evaluating your investment portfolio, you must look beyond the expected return. Other critical measures help you assess what you can expect from your portfolio. Here are some additional metrics to consider:

1. Standard deviation: This measures how much returns typically vary from the mean. A higher number means more volatility and potentially more risk.
2. Dividend yield: This is the annual dividend given as a percentage of the stock price. It's a simple way to gauge potential income from an investment.
3. Price-to-earnings (P/E) ratio: The P/E ratio compares a company's stock price to its earnings per share. A lower P/E generally indicates a good value.
4. Debt-to-equity ratio: This measures how much debt a company has relative to its equity. A lower ratio often suggests a stronger financial position.
5. Return on Equity (ROE): This measures how efficiently a company uses shareholders' money to generate profits. A higher ROE is generally better.
6. Historical performance: While past performance doesn't guarantee future results, looking at one-year, five-year, and 10-year returns can provide context.
7. Maximum drawdown: This is the broadest peak-to-trough decline in an asset's value over a specific period. It helps when considering the worst-case scenarios.
8. Risk-adjusted returns: This compares an investment's return to the amount of risk taken to achieve that return. It helps you understand if the potential reward is worth the risk. A standard measure of risk-adjusted return is the Sharpe ratio, which compares returns above a risk-free rate to an investment's volatility.
   

The Bottom Line

Expected portfolio returns are a fundamental measure of the potential gains you can expect from investing. It's calculated by combining the expected returns of individual securities, weighted by their proportion in the portfolio. This metric is crucial for investors to assess potential performance, compare investment prospects, and align their portfolios with financial goals and risk tolerance.

However, expected returns should be considered alongside risk, asset correlations, and various financial ratios. Expected returns are based on historical data and assumptions about the future that might not hold. Prudent investors use expected return calculations along with a broader analysis of market conditions, company-specific factors, and the wider economy.