Portfolio Expected Return: Weights and Individual Asset Returns

Imagine you are creating a delicious smoothie. You decide to blend different fruits together – maybe some bananas, strawberries, and blueberries. Each fruit has its own sweetness and flavor, right? In the world of investing, a portfolio is quite similar to this smoothie. It’s a mix of different investments, like stocks, bonds, or real estate, instead of fruits.

Just as each fruit contributes its unique flavor to the smoothie, each investment in a portfolio is expected to generate a certain return. Think of expected return as the anticipated sweetness or flavor from each fruit. Some fruits are naturally sweeter than others, and similarly, some investments are expected to perform better than others. For example, you might anticipate that a tech stock could grow more significantly than a government bond, just as you expect a ripe mango to be sweeter than a lemon.

Now, when you make a smoothie, you don’t just throw in random amounts of each fruit. You carefully decide how much banana, how many strawberries, and how many blueberries you want. This proportion of each fruit is similar to the ‘weight’ of each investment in your portfolio. The weight represents what percentage of your total investment is allocated to each asset. If you put more bananas than strawberries in your smoothie, the banana flavor will be more dominant. Similarly, if you allocate a larger portion of your investment to stocks compared to bonds, the stock’s performance will have a greater influence on your overall portfolio return.

To figure out the overall sweetness of your smoothie, you wouldn’t just add up the sweetness levels of each fruit. That wouldn’t make sense, would it? You need to consider how much of each fruit you actually used. It’s the same with a portfolio. To calculate the expected return of your entire portfolio, you can’t simply add up the expected returns of each individual investment. Instead, you need to consider both the expected return of each asset and the weight of that asset in your portfolio.

The process is actually quite straightforward. For each investment in your portfolio, you multiply its expected return by its weight. This gives you the weighted expected return for that specific investment. You do this for every investment in your portfolio. Then, to get the expected return of the entire portfolio, you simply add up all these weighted expected returns.

Let’s take a simple example. Imagine you have a portfolio with two investments. Investment A is expected to return 10 percent, and you’ve allocated 60 percent of your portfolio to it. Investment B is expected to return 5 percent, and you’ve allocated the remaining 40 percent to it.

To calculate the portfolio’s expected return, you first find the weighted expected return for Investment A. That’s 10 percent multiplied by 60 percent, which equals 6 percent. Then, you find the weighted expected return for Investment B. That’s 5 percent multiplied by 40 percent, which equals 2 percent. Finally, you add these two weighted expected returns together: 6 percent plus 2 percent, which equals 8 percent. So, the expected return of your portfolio is 8 percent.

In essence, the portfolio’s expected return is a weighted average of the expected returns of its individual assets. It reflects the combined anticipated performance, taking into account how much of your investment is placed in each asset. This method allows investors to understand the overall expected performance of their diversified portfolio, rather than just looking at the potential of individual investments in isolation. Just like you consider the proportions of each fruit to understand the overall taste of your smoothie, investors use weights to understand the overall expected return of their portfolio. It’s a crucial tool for making informed decisions about asset allocation and portfolio construction.