Setting Expectations for Stock Returns
The past may not be a good guide for the future, but a forward-looking framework can help investors set realistic return expectations.
It is vital for investors to set reasonable expectations for future returns. This not only facilitates better planning but can also help investors gauge whether an asset offers sufficient compensation for its risk and better compare different investments.
To illustrate the concept of expected returns, consider a casino with an American roulette wheel. There are 38 spaces on the wheel and 18 are red. If a gambler places a $1 bet on red and wins, he receives $1. Otherwise, the casino gets the dollar. The casino's expected return on this bet is: ((18/38)*-1) + ((20/38)*1) = 5.26%. That doesn't mean that the casino will necessarily generate a return of 5.26% each round, only that we would expect this return, on average, if the game were played thousands of times. (The odds favor the house.)