Expected Rate of Return

"Price is what you pay. Value is what you get." ~ Warren Buffet.

This simple statement speaks volumes on investments and expected rate of return. Take an instance: You grow a sapling. You water it regularly. The sapling continues to grow and finally matures into a big tree that yields you fruits. Now compare this with the business perspective of modern world. It is quite similar. Here business is the sapling, water is the money and fruits are the returns on investments. So, what is investment? It is the combination of efforts, money and belief that you invested in blooming your business.

What is Expected Rate of Return
Usually, the term rate of return, is the most frequently used term when making investments in stocks and mutual funds. Following is a sample questionnaire that will help you in planning an investment and expected rate of returns on it.

• How much money you want to invest? Is it going to be a one time investment or will it be recurring?
• Are there any taxes associated with your planned investments?
• What are the research and maintenance costs that will be incurred to evaluate your investment?
• Money is important. But time beats money in value. So, how much time will you take to invest?
• And last but not the least, how much return is expected on your investment and when? If not sure, figure out how much interest will be earned on the capital amount?

A return rate can be termed as a rate at which the returns are earned on a capital invested. These returns may include the income on the capital earned or lost during investments. For example: You buy 10 notebooks each costing $2. So, your investment is $20. Now you plan to sell each notebook for $3. So, the amount you earn at the close of business is $30. The returns on your capital is $30 of which $10 is your profit. So, your return rate is 50%. This was a very simple example to understand the rate of return rate concept. But then if you peep into the functioning of the stock market, although the concept remains the same, calculating rate of return becomes more challenging. Say, you have an investment of $100. A year later the capital worth is $200. So, your rate of return is 100%. But then a year later due to some economic debacle, your investment falls to $100 again. So, now your rate of interest on the capital invested is -50%. Expected rate of interest in stock markets and huge investments follow the theory of probability as well.

Rate of Return Formula
Expected rate of return = 1ⁿ[P(i)*r_i]

where:
r_i = returns.
P(i) = probability of returns (r_i) achieved
n = number of investments for which the returns are anticipated

For instance, you own a stock ABC. Its current value is $10. The stock market experts predict that by the end of this year, the stock value might soar by 15% if the economic growth hits up by 25%. Opinions differ from experts to experts. Others feel that the stock value may increase by 12% if the economic growth is higher than 40%. In some cases, it is predicted that the stock value might plummet by 5% if there is an anticipation of a fall in the economic growth by 15%. Now the rate of return will be

(25%*15%) + (40%*12%) + (5%*(-)15%) = 0.0375 + 0.048 - 0.0075 = 0.078

Here 7.8% is the expected rate of return.

Expected rate of return calculation is an integral part of any business and for people who buy stocks to invest. Every person who invests should always anticipate a higher return on the capital he has put through. In stocks, the simple fundamental that is followed regarding the rate of return is that the value at which a stock is purchased must always be lower than the current value. This is because the selling of the stock depends on the supply demand process in the stock market, over which one cannot have much control.