Here is a quick overview of expected return:
Our 5-year expected return calculation gives context to the stress test risk number seen throughout HiddenLevers. The main benefit of this calculation is the ability to see the risk/reward trade-off immediately.
Here is a detailed explanation of how the number is calculated:
To calculate the expected return, first we need to set our assumptions. The assumptions are the scenarios that could possibly play out in the economy. The Primary Scenario is the scenario that occurs between 66% (least likely) and 98% (most likely) of the time, with neutral being 82%. It is generally recommended to use a positive outcome as the primary scenario (such as S&P up 10%) because of the tendency of the market to only correct twice every ten years. The additional scenarios account for the rest of the calculation, using relative weights based on selected probability and the number of scenarios chosen. Scenarios can either be kept at their default neutral probability, or customized.
Once the default scenarios are set, HiddenLevers calculates the one-year weighted average expected return across these scenarios. The one-year expected return is then compounded to obtain a 5-year return estimate. Again, since major downside events occur roughly twice a decade, this is an appropriate timeframe to compare long-term returns and downside stress test risk.
With this calculation, you now have a better idea of what upside you can expect for the risk you are taking.