What Is Mean Return?
Mean return, in securities analysis, is theexpected value, or mean, of all the likely returns of investments comprising a portfolio. A mean return is also known as an expected return and can refer to how much a stock returns on a monthly basis. Incapital budgeting, a mean return is the mean value of theprobability distributionof possible returns.
Key Takeaways
- A mean return (also known as expected return) is the estimated profit or loss an investor expects to achieve from a portfolio of investments.
- It can also refer to monthly stock returns or the mean value of the probability distribution of possible returns.
- An investor can calculate the mean return on an investment given the investment's historical returns or probable rates of return under different scenarios.
- Calculating a mean return can help an investor quantify the relationship between the risk of a portfolio of securities and the potential return.
- However, a mean return does not guarantee a future rate of return and is only one tool that an investor should consider when evaluating an investment before purchasing it.
Understanding Mean Return
An important component of stock analysis is to project a stock's future worth. Investors and analysts will attempt to estimate future revenue and growth as a way of determining if a particular investment is worth the risk involved.
Calculating the mean or expected return of a portfolio of investments can help the investor achieve a better understanding of how specific securities can impact the portfolio as a whole. By adding and removing securities as part of the analysis process, the investor can visualize the pros and cons of each investment and build a portfolio that meets their tolerance for risk.
The process of calculating a mean return can help an investor in deciding on the best asset allocation and in comparing securities within the same industry as potential investments for inclusion in a portfolio.
Calculating Mean Return
Mean returns are calculated by adding the product of all possible return probabilities and returns and placing them against the weighted average of the sum. When calculating a mean return through the return probability formula to display portfolio return, it is often referred to as a geometric mean return since it evokes the formula for means used in geometry.
However, the simple geometric mean does not adequately capture the full scope of the mean return as used in the stock market. The geometric mean return formula is primarily used for investments that are compounded. You can find the average mean for other simple interest accounts by simply adding the rates and dividing by the time periods. Alternatively, a geometric mean return formula can illustrate the rate per period of a holding period return, with the holding period return acting as the total return over multiple periods of time.
You can calculate capital budgeting finance mean returns a little differently, but similarly. The formula for capital budgeting uses maximum risk-tolerance weighted returns instead of the probabilities of the return.
Mean returns are not the same as average monthly returns, because a mean return would only reflect the average return if the time period used in the calculation was exactly a year and if all the probable weights happened to be precisely the same, which is improbable. Thus, mean return is more of a broad term instead of an average monthly statistic over a period of time.
Benefits of Mean Return
Mean returns attempt to quantify the relationship between the risk of a portfolio of securities and its return. It assumes that while investors have differentrisk tolerances, rational investors will always seek the maximumrate of return(RoR) for every level of acceptable risk. It is the mean, or expected, return that investors try to maximize at each level of risk.
Mean returns can also help investors more accurately visualize a proportional change in wealth over the time horizon and through analysis, showing what the rate of return could potentially continue at. While mean returns use the known historical RoR of an investment, this does not guarantee that the investment will continue to achieve the same RoR in the future.
For this reason, the prudent investor will use a mean returns analysis as just one tool in the investment decision-making process. An investor doing a stock analysis should also review the company's financial statements and evaluate management's strategies for future growth.
