What is absolute return on an investment?

Absolute returns are an important metric for investors to get a broad idea of how their investments are performing. Unlike relative return, which compares an investment's performance to a benchmark index, absolute return focuses solely on the actual gains or losses.

What is absolute return?

In simple terms, the absolute rate definition is the point-to-point gain or loss realised by an investment. Absolute return is expressed as a percentage of the invested value. It does not accommodate factors such as how long the investment has been held or market trends and economic conditions.

How to calculate absolute return?

Absolute return is calculated using the below formula:

Absolute Return = {(Final Value - Initial Value) / Initial Value} * 100

For example, if someone initially invests Rs.1,000 and gets a final value of Rs.1,200, the absolute return would be {(Rs.1,200 - Rs.1,000) / Rs.1,000} * 100 = 20%. This indicates a 20% absolute return on the investment. This metric does not take into account the investment duration. The 20% growth may have happened over one year, in which case it would be a significant rise, or 10 years, in which case the yearly growth would have been minimal.

Understanding absolute return for an asset class

It's important to remember that absolute return can vary significantly across different asset classes. For example, equity investments historically exhibit a relatively higher absolute return potential than bonds, but also come with more volatility. Thus, understanding the inherent risk-return characteristics of each asset class is crucial for interpreting absolute return figures. However, the metric can give a rough idea of the growth potential an asset class could offer.

Applications of absolute return:

Though absolute return has its limitations and does not give a holistic picture of how an investment is performing, the broad overview it offers can help in portfolio planning.

Evaluating investment strategies: Absolute return can be used by investors and fund managers to assess the effectiveness of investment strategies. By tracking the absolute return of different strategies over time, they can make informed decisions about allocation and diversification.

Setting target returns: Investors can look at absolute returns while setting targets for their portfolios. This can help them align their investment goals with their risk tolerance and market expectations.

Comparing investment options: While not the sole factor, absolute return can be used to compare the historical performance of different investment options, providing insights into the return potential and associated risks.

Conclusion

Absolute return, with its focus on actual investment performance independent of market benchmarks, is a useful metric for assessing portfolio growth and managing risk. By understanding absolute return meaning and importance, investors can make informed decisions aligned with their investment objectives and risk tolerance.

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