How to calculate volatility of a stock

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?


Category: Forex

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