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Expected Return Definition and Quiz

Beginners are often surprised (and confused) by the fact that scholars can't seem to settle on one term for the concept of expected return.

Define - Define expected return for investments.
Context - Use expected return in a sentence.
Quiz - Test yourself.

by Paul Alan Davis, CFA

Published: September 02, 2016

Updated: February 17, 2021

There is a subtle but important distinction between expected return and forecast return. Learn more below.

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Finding expected returns for investments

Intermediate

Expected Return is the return on an asset that is baked-in to market expectations at the present time. An active manager will compare expected return to forecast return when deciding whether an asset is cheap or expensive. This is typically derived by multiplying an asset's beta (see CAPM) by the expected return on the Market.

Synonyms: consensus return, implied return, equilibrium return

For context, it helps to think of three timeframes in investments: past, present and future. Because most investors can't fathom how to set expected returns on their own, they use past returns. When this is input as the numerator in a mean-variance optimization (MVO) for example, the results are biased for what happened in the past which isn't a good way to go about investing.

CAPM offers a way to see what is baked into current expectations for an investment, thereby setting an expected return. From there, an active investor who forecasts a different return can position the portfolio to benefit from this mispricing.

In a Sentence

Pam: The stock had a beta of 2, but then diversified. So that can't be a valid expected return.
Eve: I agree, run it through the 3-factor model. Jeez, look at us, now we sound like quant geeks.

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Quiz

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A stock's beta matches the market and you expect the market to increase by 8%. The forecast for the stock is 9%. What is the stock's expected return. | 7% or 8% or 9%?

The exercise fundamental active managers go through to generate an intrinsic value on a stock is suited for setting returns in which timeframe? | Past, Present or Future?

Future

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/ factorpad.com / fin / glossary / expected-return.html

expected return

consensus return

implied return

equilibrium return

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market expectations

capm model

capital asset pricing model

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modern portfolio theory

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