In this blog, we will delve deeper into the absolute return formula, its importance, and how it can be used to measure the success of an investment.
What is the Absolute Return Formula?
The absolute return formula is a simple calculation used to measure the percentage increase or decrease of an investment over a specific period. The formula is as follows:
Absolute Return = ((Ending Value – Beginning Value) / Beginning Value) x 100
In this formula, the ending value is the value of the investment at the end of the specified period, and the beginning value is the value at the beginning of the period. The result is then multiplied by 100 to convert the answer into a percentage.
Why is Absolute Return Important?
Absolute return is an important metric because it provides investors with an accurate measure of how their investments have performed over a given period. Unlike relative return, which measures an investment’s performance against a benchmark or index, absolute return provides investors with a clear understanding of the actual returns they have earned.
Using absolute return to measure investment performance is particularly important in volatile markets where benchmark indices may not accurately reflect the actual performance of an investment. It’s also a useful metric for comparing the performance of different investments.
How to Use Absolute Return
The absolute return formula can be used to calculate the returns of a single investment or a portfolio of investments. By calculating the absolute return of each investment in a portfolio, investors can determine the overall performance of their portfolio.
It’s important to note that absolute return is only one metric for measuring investment performance. It should be used in conjunction with other metrics, such as relative return, risk-adjusted return, and volatility, to get a complete picture of an investment’s performance.
Benefits of Using Absolute Return Formula
- Provides a clear understanding of investment performance: As mentioned earlier, absolute return provides investors with a clear understanding of how well their investments have performed over a specific period. This can help investors make informed decisions about whether to hold, sell, or buy more of a particular investment.
- Useful in volatile markets: In volatile markets, benchmark indices may not accurately reflect the performance of an investment. Absolute return can be a useful metric in such markets, as it provides investors with an accurate measure of their investment’s performance.
- Allows for easy comparison of different investments: By calculating the absolute return of different investments, investors can easily compare their performance and make informed decisions about where to allocate their funds.
- Helps in setting investment goals: Knowing the absolute return of an investment can help investors set realistic investment goals and track their progress towards achieving those goals.
Limitations of Using Absolute Return Formula
- Doesn’t account for time: The absolute return formula does not account for the time period over which the investment was held. Two investments may have the same absolute return, but one may have taken longer to achieve that return, indicating that it may not have been the best investment.
- Doesn’t consider the risk: The formula only looks at the percentage increase or decrease of an investment, and does not consider the level of risk associated with the investment. An investment may have a high absolute return but also be very risky, making it less attractive to some investors.
- Ignores dividends: The formula does not take into account any dividends paid by the investment. For example, an investment in a stock that pays a high dividend may have a lower absolute return than another investment with a higher price appreciation but no dividend.
Conclusion
The absolute return formula is a useful tool for measuring the success of an investment, providing investors with a clear understanding of how well their investments have performed. However, it’s important to note that absolute return is only one metric for measuring investment performance and should be used in conjunction with other metrics to get a complete picture of an investment’s performance. Ultimately, investors should consider their investment goals, risk tolerance, and other factors when using the absolute return formula to make investment decisions.
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Frequently Asked Questions (FAQs) about Absolute Return Formula
Q.What is the difference between absolute return and relative return?
Absolute return is a measure of the total percentage increase or decrease of an investment over a specific period, whereas relative return is the measure of an investment’s performance compared to a benchmark or index.
Q.How is the absolute return formula calculated?
The absolute return formula is calculated by subtracting the beginning value of an investment from its ending value, dividing that result by the beginning value, and multiplying by 100 to convert it into a percentage. The formula is as follows: Absolute Return = ((Ending Value – Beginning Value) / Beginning Value) x 100.
Q.Can absolute return be negative?
Yes, absolute return can be negative. If an investment loses value over a specific period, the absolute return will be negative.
Q.What is a good absolute return?
The answer to this question depends on the investor’s investment goals, risk tolerance, and other factors. A good absolute return for one investor may not be the same for another investor.
Q.Can the absolute return formula be used for all types of investments?
Yes, the absolute return formula can be used for all types of investments, including stocks, bonds, mutual funds, and ETFs.
Q.Is absolute return the only metric to consider when evaluating investment performance?
No, absolute return is only one metric to consider when evaluating investment performance. Other metrics, such as relative return, risk-adjusted return, and volatility, should also be considered to get a complete picture of an investment’s performance.
Q.Does the absolute return formula take into account the time period over which the investment was held?
No, the absolute return formula does not take into account the time period over which the investment was held. This can be a limitation when comparing two investments that achieved the same absolute return over different time periods.
Q.Can the absolute return formula be used to compare the performance of different investments?
Yes, the absolute return formula can be used to compare the performance of different investments. By calculating the absolute return of each investment, investors can easily compare their performance and make informed decisions about where to allocate their funds.
