The expected rate of return is the return on investment that an investor anticipates receiving. It is calculated by estimating the probability of a full range of returns on an investment, with the probabilities summing to 100%. For example, an investor is contemplating making a risky $100,000 investment, where there is a 25% chance of receiving no return at all. There is also a 50% probability of generating a $10,000 return, and a 25% chance that the investment will create a $50,000 return. Based on this information, the expected rate of return is:
$0 return x 25% = $0 return
$10,000 return x 50% = $5,000
$50,000 return x 25% = $12,500
The investor then sums these projections to arrive at an expected rate of return of $17,500, or 17.5%, which is calculated as:
$17,500 sum of returns ÷ $100,000 investment = 17.5% expected rate of return
Since the probabilities used in these projections are qualitative in nature, it is quite possible that two people using the same information will come up with different probability percentages, and therefore different rates of return. This is especially the case when the individuals use historical information as the basis for their projections; historical results do not necessarily translate into future results.