Investors often quote their returns in absolute terms. For example, they might say they earned an 8% return on their portfolio. But if we're really trying to measure the performance of an investment, then we need to understand absolute versus relative returns too.
In this article, we're going to explain the differences between absolute return, also known as total return, and relative return. As part of that explanation, we'll first provide a definition of each term, as well as its calculation. Next, we'll talk about why it's important to consider both measures of an investment's performance, and provide examples to illustrate this point. Finally, we'll summarize the value of these two terms, and explain how they can be used by investors to evaluate the growth of their holdings.
The most commonly reported measure of an investment's performance is its absolute return. Unfortunately, this metric only provides half the story. Whenever an investor is trying to answer the question: How well is this investment performing? The answer needs to be stated in both absolute as well as relative terms.
As mentioned, the absolute return is the measure most investors talk about, or read about, when discussing, or researching, an investment. The calculation of absolute return is straightforward, and takes the following form:
Absolute Return = (Current Value - Original Investment) / Original Investment
Absolute return is typically reported on an annual basis, and is usually stated as a percentage. We're going to demonstrate this calculation in the example that follows.
In this first example, we have an original investment of $1,000, which grew to $1,500 after two years. Using the formula above, we know:
Absolute Return = ($1,500 - $1,000) / $1,000
Absolute Return = $500 / $1,000 = 0.50, or 50%
If we want to state the above return on an annual basis, then we would divide the absolute return by the number of years over which the return occurred. In this example, the absolute return would be 50% / 2 years, or 25% per year.
The relative return on an investment provides the investor with insights into the performance of the asset relative to a benchmark. For example, the investor might want to evaluate the performance of a domestic stock mutual fund versus the S&P 500 Index. By comparing the return of an investment to a benchmark, it's possible to better understand its performance versus alternatives.
Since the relative return takes into consideration a benchmark, the calculation is slightly more complex than absolute return:
Relative Return = Absolute Return of Investment - Absolute Return of Benchmark
Interestingly, the above equation provides additional insights into the relationship between these two measures.
In this second example, we have an original investment of $1,000, which grew to $1,500 after two years. In addition, our benchmark investment of $1,000 grew to $1,100 during that same timeframe. Using the formula above, we know:
Absolute Return of Investment = 50% (as solved in our first example)
Absolute Return of Benchmark = ($1,100 - $1,000) / $1,000
Absolute Return of Benchmark = $100 / $1,000 = 0.10, or 10%
Substituting the above values into our equation:
Relative Return = 50% - 10% = 40%
Once again, if the investor wants to state the above return on an annual basis, then they would divide the relative return by the number of years. In this example, the relative return would be 40% / 2 years, or 20% per year. That is to say, the investment outperformed its benchmark by 20% per year.
Now that we know how to calculate each return, it's time to discuss the value each concept provides to investors. Perhaps the easiest way to discuss the worth of each term is to summarize their pros and cons:
|Absolute Return||A familiar term to most investors, values can be quickly found in stock and mutual fund prospectuses, simple to calculate.||Does not take into consideration the fact investors have choices, relies on investors to compare returns when researching alternatives.|
|Relative Return||Provides investors with insights into the performance of an investment relative to a benchmark. If the benchmark chosen is the rate of inflation, provides investor with growth of money in real terms.||Requires more work to calculate, investor needs to select benchmark investment. Unless the benchmark chosen is the rate of inflation, does not provide the investor with an indication of real growth. For example, the relative return could be 10%, but the absolute return of the investment might be -20%, and the absolute return of the benchmark -30%.|
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