Expected Return Using Probability Theory
In lieu of a crystal ball, an investment adviser who wants to try to predict future returns may use probability theory to calculate an expected return. Expected returns differ from the returns that we have discussed thus far because they are forward-looking and, hence, unknown, as opposed to historical returns, which are known.
One common method for determining an expected return is to use historical data to develop probabilities of different returns. These probabilities are combined to come up with a composite expected return.
expected return = (probability x return) + (probability x return)
This is best demonstrated through examples.
Example Question
Based on historical information, Big Brokerage has calculated that an investment in XYZ Corporation’s comm