Absolute return is the percentage amount that an asset rises or declines in value over a specified period. Unlike relative return, which benchmarks a specific performance against a market index or another standard, absolute return focuses purely on the individual performance of the asset.
Definition of Absolute Return
In finance, absolute return is expressed as the overall change in value of an asset or portfolio over a set period, without any comparative reference to other investments or indexes. It is important as it provides investors with a clear understanding of the actual gain or loss experienced.
Mathematically, absolute return (AR) can be formulated as:
Where:
- Ending Value is the final value of the asset or portfolio after the period.
- Beginning Value is the initial value of the asset or portfolio at the start of the period.
Example of Absolute Return
Consider an investor who buys stock in Company XYZ at the beginning of the year for $100 per share. At the end of the year, the investor sells the stock for $120 per share. The absolute return on the investment is calculated as follows:
This shows that the investor achieved a 20% absolute return over the course of the year.
Absolute Return vs. Relative Return
Key Differences
Benchmark Comparison:
- Absolute Return: Measures the gain or loss of an investment in isolation, without comparisons.
- Relative Return: Assesses performance against a benchmark, such as a market index or peer group.
Performance Assessment:
- Absolute Return: Provides a straightforward assessment of profit or loss, offering a clear picture of the investment’s performance.
- Relative Return: Helps investors understand how an investment performs in the context of its market or sector.
Use Cases:
- Absolute Return: Preferred by absolute return funds and investors focusing on total gains regardless of market conditions.
- Relative Return: Used by mutual funds and hedge funds to compare performance with specific benchmarks.
Practical Considerations
Investors might choose to focus on absolute return when they are unconcerned with how an investment performs relative to its peers, instead prioritizing the total profit. This approach is commonly associated with absolute return funds, which aim to generate positive returns in both rising and falling markets.
Conversely, relative return is more relevant in environments where comparative performance is critical, such as mutual funds benchmarking against the S&P 500 Index.
Related Terms and Concepts
Return on Investment (ROI)
ROI is a broader measure of profitability that calculates the return on an investment relative to its cost. Unlike absolute return, ROI often considers various factors, including income generated from the investment and its appreciation or depreciation in value.
Benchmark
A benchmark is a standard or point of reference against which the performance of a security, mutual fund, or investment manager can be measured.
FAQs
What is the significance of absolute return in investment?
How does absolute return differ from total return?
Can absolute return be negative?
References
Summary
Absolute return is a crucial metric that conveys the gain or loss of an investment or asset over a set period, assessed independently of any benchmarks. This concept is vital for investors seeking to comprehend the total performance of their investments without involving relative comparisons. Understanding absolute return, along with its distinction from relative return, equips investors with essential insights for making informed financial decisions.
