What is the difference between Absolute and Annualised return?
Absolute return measures the performance of investment regardless of the time period. It is expressed in terms of percentage and INR. On the other hand, the annualised return is the average return of an investment over a period of time. It is expressed as a percentage.
Absolute returns are easy to calculate. It takes the beginning value or initial investment and the end value to calculate the return from the investment. The annualised return, on the other hand, is slightly difficult to calculate. It takes the absolute return and adds 1 to it. Then the nth root of it is taken where n is the time period, and finally, one is subtracted to obtain the annualised multiplier. In other words, it shows the return from an investment over a period of time.
Though it is easy to calculate, it gets challenging to compare the absolute return from 2 investments. The time period of comparison when the return is calculated is unknown, hence making it difficult for comparison. On the other hand, one can compare the annualised return of two investments and can choose the one with a higher annualised return.
Let’s take an example of investing INR 1,000 for three years. At the end of 3 years, the investment grew to INR 1,500. The absolute return from this investment is 50%. On the other hand, the annualised return is 14.47%. This means the investment grew 14.47% per annum for three years.
What is the absolute and relative return?
Absolute return is the return of an investment over a certain period of time. On the other hand, the relative return is the difference between the absolute return of an investment and its benchmark over a period of time. Relative return is also called alpha.
Absolute return on its own doesn’t convey much about an investment. However, one can compare it to the market to infer how the investment is performing. When the actual return is compared to the benchmark return, the difference between the two is called the alpha or relative return. A high alpha is a good indicator that the investment is good.
One can understand these better with market cycles. In a bullish market phase, a fund giving 10% return when compared to the benchmark return of 15% is considered as bad as the relative return or alpha is negative (-5%). However, in a bearish phase, when the market is down by 10%, a 2% return from the investment is not bad. As the market fell by 10%, but the investment managed to give a positive return of 2% (alpha 12%).
How do you calculate absolute return?
Absolute return is the measure of an investment’s performance over a period of time. One can calculate it using the formula below.
Absolute return = (Current value/initial value) – 1
Let’s take an example of an investor Ms Anjali who invested INR 50,000 5 years back, and the current value of her investment is INR 75,000. The return of Ms Anjali’s investment is
Return = (75000/50000)-1
Return = 50%