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| What's the difference between absolute and relative return? |
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It might seem simple, but knowing whether a fund manager or broker is doing a good job can be a challenge for some investors. It's difficult to define what good is, because it depends on how the rest of the market has been performing. For example in a bull market, 2% is a horrible return. But in a bear market, when most investors are down 20%, just preserving your capital would be considered a triumph. In that case, 2% doesn't look so bad.
So, the absolute return is simply whatever an asset or portfolio returned over a certain period. In the paragraph above, the 2% we mentioned would be the absolute return. If a mutual fund returned 8% last year, then that 8% would be its absolute return. Pretty simple stuff.
Relative return, on the other hand, is the difference between the absolute return and the performance of the market (or other similar investments), which is gauged by a benchmark, or index, such as the S&P 500 Relative return is the reason why a 2% return is bad in a bull market and good in a bear market. (If you aren't familiar with indexes, read more on them in our Index Investing tutorial).
For example, if the absolute return of your portfolio is 10% and the performance of the S&P 500 during the same time period is 6%, then you have a relative return of 4% greater than the market (10% - 6% = 4%). If, however, during this same time period the S&P 500 returns 15%, then you have a relative return of -5% (10% - 15% = -5%).
Why is relative return so important? Because it is a way to measure the performance of actively managed funds, which should get a return greater than that of the market. After all, you can always buy an index fund that has a low management expense ratio (MER) and will guarantee the market return. If you're paying a manager to perform better than the market and the investment doesn't have a positive relative return over a long period of time, it may be worth your time shopping around for a new fund manager!
Relative return can also be used within a context smaller than the entire market. For example, a technology fund's performance could be measured or benchmarked against other technology funds.
The bottom line is that absolute return does not say much on it's own. You need to look at the relative return to see how an investment's return compares to other similar investments. Once you have a comparable benchmark in which to measure your investment's return, you can then make a decision of whether your investment is doing well or poorly and act accordingly.
(For further reading on returns, check out our article The Truth Behind Mutual Fund Returns.)
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