Assess the most likely returns and probability of return for different economic conditions for a specific investment. Choose Stock XYZ for this example. Assume that the price of Stock XYZ will increase by 20 percent if the economy expands during the next year. Also assume that the probability of the economy expanding during the next year is 40 percent.
Now assume that the price of Stock XYZ will decrease by 40 percent if the economy contracts in the next year. Also assume that the probability of the economy contracting during the next year is 60 percent.
Add the probabilities of the events and verify that they total 100 percent. Conclude, for this example, that the sum of the probabilities is 100 percent, since 40 plus 60 is 100. Assume different probabilities if the sum of the probabilities does not add up to 100 percent. Conclude that since the probabilities for this example equals 100 percent, different probabilities will not have to be chosen.
Multiply the assumed returns by the assumed probabilities for each economic situation. First, convert all numbers expressed as percentages to decimal numbers by dividing by 100. Calculate for this example that 40 percent is equal to 0.4, 60 percent is equal to 0.6, and 20 percent is equal to 0.2.
Calculate for this example that the upside return for stock XYZ is 0.08 if the economy expands, since 0.2 times 0.4 is 0.08. Calculate for this example, that the downside return for stock XYZ is 0.24 if the economy declines, since 0.4 times 0.6 is 0.24.
Calculate the expected rate of return. Total all the individual returns for the different economic scenarios. Calculate that the expected rate of return for this example is negative 0.16 or negative 16 percent. Conclude that this must be true, since 0.08 minus 0.24 is negative 0.16, and negative 0.16 times 100 is negative 16 percent.