When comparing investments, returns are one of the metrics you might zero in on. But there are different ways to gauge an investment’s performance. Absolute return measures an investment’s returns over a set time period. When choosing where to invest money or assessing the performance of investments you already own, this can be a useful metric to understand. Calculating absolute return involves applying a simple formula. You can then compare it to an investment’s relative return to help decide if it’s something you should add to your portfolio.
Use the services of a financial advisor to make sure you’re taking full advantage of the most appropriate analytical tools.
Absolute Return Definition
Absolute return isn’t a complicated investing concept. It simply means the gain or loss generated by an investment over a set time period. Following that definition, absolute returns can be positive or negative, depending on how an investment has performed.
You can apply this metric for measuring returns to a single security or to an entire portfolio. For example, if you’re considering buying into a particular tech stock you could use the absolute return formula to measure its performance over the last six months.
Or you could analyze absolute returns for your entire portfolio year-over-year. Either way, knowing how to calculate absolute return can help when it comes to making more informed decisions about where to invest your money.
Absolute Return Formula
As mentioned, there’s a specific formula that’s used to calculate absolute return. To find it, you need to know two things:
- The current value of the investment
- The purchase value of the investment
The absolute return formula looks like this:
Current value – Purchase value / Purchase value X 100
If you’re using this formula to measure absolute return for an investment you already own, you’d simply plug in what it’s worth now versus what you paid for it, divide it by the original purchase value and multiply the answer by 100.
You could also use this formula to calculate the absolute return for investments you don’t own. You’d need to choose a time period for running the calculation, then plug in the current value and purchase value of the asset for the corresponding beginning and ending dates.
Overall, it’s a very simple formula that can give you an idea of how investment securities have performed over time.
Absolute Return Example
Seeing some examples of absolute return can make it easier to understand. So, let’s assume you bought 100 shares of XYZ stock for $15 each in January 2020. Fast forward to January 2021 and those shares are now worth $25 each.
Using the absolute return formula, the math would look something like this:
$25 – $15 / $15 X 100 = 66.67%
In other words, you’ve earned 66% on those shares of stock during that one-year period.
Now, assume that the numbers are reversed. You paid $25 per share but now they’re worth $15 per share, thanks to stock market volatility.
The absolute return formula would look like this:
$15 – $25 / $25 X 100 = -40%
So you end up with a negative 40% return instead.
On paper, the numbers may look great if they result in a positive return. But keep in mind that absolute return doesn’t give you a complete picture of an asset’s performance. It’s also important to consider the relative return as well.
Absolute Return vs. Relative Return
Relative return is another way to measure performance, and it takes absolute return into account. What you’re measuring here is an asset’s return over a set time period, relative to how a particular benchmark has performed. It is similar to the idea of a security’s alpha. To calculate the relative return, you’d first need to find the absolute return for an investment. Then, you’d calculate the difference between the asset’s absolute return and a benchmark or index return.
The biggest difference between absolute return and relative return is that absolute return only looks at one asset or one portfolio. There are no comparisons made between it and anything else. With the relative return, you can gauge how a security or portfolio is doing against the larger backdrop of the market.
It’s important to remember that relative return is subjective and how you interpret it can depend on what’s happening with the market at any given time. When the market is booming and posting a 20% annual return for the year, for example, then you might feel underwhelmed by your portfolio’s performance if it’s only generating a 7% return.
On the other hand, when the market’s down a 7% annual return could be a good thing if that’s on par with or above a specific benchmark or index’s return. Keeping absolute return and relative return in perspective matters when deciding how to invest.
How to Use Absolute Return as an Investor
Absolute returns offer a snapshot of how an asset or investment has performed during a specific window of time. Using this metric to construct a portfolio typically centers on one goal: driving positive returns as much as possible.
Absolute return funds are one way to achieve that goal. These mutual funds focus on diversification to manage risk while also promoting positive returns, independent of what may be happening with a particular market benchmark.
What sets them apart from other types of mutual funds is their investment strategy and how they’re managed. For example, these funds may invest in both domestic and international stocks, along with fixed-income securities and alternatives, such as commodities and futures. The way they’re structured can make them seem remarkably similar to hedge funds, though they can be more accessible to everyday investors than hedge funds.
The upside of these funds is that they can minimize volatility impacts while still generating income even during market downturns. The trade-off is that because they require active management, they may come with higher expense ratios than other types of mutual funds.
If you’re interested in using absolute return funds to your advantage, you may be able to invest in them through your online brokerage account. If you don’t have a taxable investment account yet, there are plenty of online brokers that offer commission-free trading to choose from.
The Bottom Line
There are several other types of returns, including trailing returns and rolling returns. Absolute return offers a very simplified view of an investment or portfolio’s performance. When used alongside other metrics, such as relative return, it can be helpful for managing your investment strategy. Investing in absolute return funds is one option for promoting positive returns through up and down market cycles.
Tips for Investing
- Consider talking to a financial advisor about how absolute return works and what it means for your portfolio. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool makes it easy to connect with professional advisors in your local area. It takes just a few minutes to get your personalized advisor recommendations online. If you’re ready, get started now.
- The stock market can be volatile. While it’s important to watch it for patterns, you can take hands-on measures to guard your finances. For example, an asset allocation calculator can help you create and maintain a diversified portfolio that will help buffer your portfolio as the market goes through bullish and bearish phases.
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