How is the expected return of an investment calculated?

The expected return of an investment is calculated by multiplying each potential outcome by its probability and then summing these values. This method takes into account the different possible returns the investment can yield and the likelihood of each outcome occurring.

To break it down, the process involves identifying all the possible returns that an investment could generate and determining the probability of each return happening. For instance, if an investment has a 30% chance of returning 10%, a 50% chance of returning 5%, and a 20% chance of losing 2%, you would calculate the expected return like this:

• For the 10% return: 0.30 * 10% = 3%
• For the 5% return: 0.50 * 5% = 2.5%
• For the -2% return: 0.20 * (-2%) = -0.4%

Adding these results together gives you the expected return of the investment. This calculation is crucial in finance because it allows investors to evaluate the potential profitability of different investment options based on their risk and the likelihood of various outcomes.