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How to Calculate the Expected Return on a Portfolio
By JLP | January 19, 2007
Most of the readers of this blog already know how to make this calculation. However, one my goals for AllFinancialMatters is to reach out to those who wouldn’t normally hang out at personal finance blogs. I do this (or at least try to do this) by taking various subjects and simplify them so that most people can understand them. Today I want to focus on how to estimate the return of a portfolio. It’s very easy to do and can really help you with planning (assuming you have rational expectations).
So, let’s begin…
First we’ll look at the total returns through 2006 for various indexes (asset classes) found in the Callan Periodic Table of Investment Returns:
Here’s the asset class that each index represents:
MSCI EAFE – International
S&P 500 Index – Domestic Large-Cap Stocks
Russell 2000 Value Index – Domestic Small-Cap Value Stocks
LB Agg Bond Index – Investment-Grade Bonds
I realize that there is no midcap index. We’ll just do without it for this example.
Now we’ll decide what percentage of the portfolio should be allocated to each asset class. It’s easy to look at the above chart and just pick out the indexes with the best returns. That’s not the way to do it! Why? Because that graphic does not show you the volatility that the index contains. Without getting into the specifics (food for another post), here’s how the asset classes rank in volatility (from least to most):
LB Agg Bond Index – Investment-Grade Bonds
S&P 500 Index – Domestic Large-Cap Stocks
Russell 2000 Value Index – Domestic Small-Cap Value Stocks
MSCI EAFE – International
Your asset allocation will depend on factors like your age, time horizon, risk tolerance (I hate that term), and other various factors. All this makes asset allocation a very personal choice. What’s right for me may or may not be right for you.
So,… here’s how we can use the information we have covered so far to estimate the total return on a portfolio:
Let’s say you have decided that you want the following allocation:
30% – Large-Cap Stocks – S&P 500 Index
30% – International – MSCI EAFE
30% – Small-Cap Value – Russell 2000 Value
10% – Bonds – LB Agg Bond Index
Using the 20-year returns from the chart above, we’ll construct the following portfolio:
As the graphic suggests, you take the percentage allocation times the expected return of the asset class to estimate that asset’s impact on the portfolio. You repeat this for each of the asset classes. Then you simply sum those returns as I did in the last column to get an idea of how a particular portfolio will perform. If you are interested, you can download a simple spreadsheet I put together. You can then play around with it by making changes to the allocations and expected returns to see their impacts on the total portfolio. You can also use my Portfolio Tool that I recently created.
If you took the time to read this post, you now have a understanding of how to construct a portfolio and how expected returns impact the return of the entire portfolio. Isn’t learning fun?
Topics: Asset Allocation, Calculators, Miscellaneous | 17 Comments »
January 19th, 2007 at 1:34 pm
great post. I’m just starting into the long term investment strategy.
January 19th, 2007 at 7:51 pm
What do you think of the theory held by some that the domestic market is mature, and that emerging markets, particularly those in China and the rest of Asia, will be the new dominant markets in around 10-15 years? How do you think that’d affect the estimates?
January 19th, 2007 at 10:31 pm
not confucius,
Emerging markets are extremely volatile. Besides, although the domestic markets may be mature, American companies will do well internationally.
I think international/emerging markets should be in a portfolio.
January 20th, 2007 at 7:49 am
Just curious why you hate the term “risk tolerance”. Is their another you prefer, or do you just not care for the idea of it?
January 20th, 2007 at 12:03 pm
[...] JLP goes through how to calculate the expected return on a portfolio. [...]
January 20th, 2007 at 6:46 pm
John,
I dislike the term because most people don’t truly understand what their true risk is in the first place. They fear “losing money” but ignore inflation, which is the real risk.
January 20th, 2007 at 11:42 pm
Everybody hates inflation, so we ignore.
Cheers
January 25th, 2007 at 2:34 pm
Very interesting post and good table compiling the data. I think what your table presents is that there is so much randomness in the data that trying to outguess the market is self-defeating in a way. I wrote a post describing my thoughts
http://extremeperspective.blogspot.com/2007/01/stocks-are-risky-dont-obsess.html
June 6th, 2007 at 4:55 am
2 things I would like to know.
First, I woukd like to know (illustration) how the expected return on the porfolia is calculated against the amount recieved at the end of the financial year?
secondly, If you chose 20th year as annualized rate does this mean payment at the end of 20 years?
please email me of a practical example from beginning to end include a realistic example of an investor with say about 1 million US$ to invest with a similar portfolio above, and show how much his return would be at the end of the 20th year. help would be appreciated.I am commerce Degree student.
July 16th, 2007 at 12:38 pm
How did you calculate “annualized” returns for each asset class? What years did you use for 3-years? 5-years? etc.?
September 16th, 2007 at 4:31 pm
A Start-Up Investors dream! Thanks
September 21st, 2007 at 8:33 pm
hey i was wondering….if i were not given probability, how do i calculate the expected return of the portfolio? i was only given like say $4000 as investment, expected return is 6.2% and beta is 0.95….
I don’t really understand this so i thought you could help me to clear my doubt… thanks
May 13th, 2008 at 10:50 pm
[...] [...]
July 11th, 2008 at 3:29 pm
Great post. It’s amazing how many people and even investment firms don’t use expected return. Considering expected return is the only intrinsic value measure that considers confidence level and risk, it ought to be used. For more information, Alpha Theory has created a portfolio management tool for hedge funds. The demos on the website can help any investor: https://www.alphatheory.com/demo.jsp
July 14th, 2008 at 10:13 am
Hi Thanks for this perfect post. I really understand how to calculate Expected return..
My question is we used 20 years for calculation, if we use 10-year or 15- year we will get different results. How we decide which time period we should choose? you can e-mail me your answer
thanks a lot again..
July 14th, 2008 at 10:16 am
Hi
Thanks for this perfect post.
I really understand how to calculate Expected return..
My question is we used 20 years for calculation, if we use 10-year or 15- year we will get different results. How we decide which time period we should choose? you can e-mail me your answer
thxx
April 18th, 2009 at 2:44 am
Hi, I realized that this is post from a while ago and I just got this from searching in google. Thank you for your sharing, I am having couple question here, if you have some time can you do me a favor and have a look at it?
I know how to calculaing the expected value, when I setting up a porfolio which contains 2 stocks, I basically analyze it base on historical datas, what is it the time frame should I use (etc,5,10,15,20 years？) and what kind of frequency should I use ( daily, weekly, monthly, yearly) Thank you very much for your time.