When you invest in mutual funds, you are often keen to know how your investment is performing. One way to gauge this is by understanding absolute returns. Absolute return is a straightforward metric that indicates the actual profit or loss generated by your mutual fund investment over a specific period.
What is Absolute Return in Mutual Funds?
Absolute return, in the context of mutual funds, represents the total gain or loss on your investment without considering the time factor. It is expressed as a percentage and gives you a direct insight into your investment's performance.
How does Absolute Return work?
- Calculating Absolute Return: To calculate the absolute return of an investment, you need to subtract the initial investment amount from the final value (including any interest, dividends, or capital gains) and then divide it by the initial investment. The result is expressed as a percentage.
- Independence from Benchmark: Unlike relative returns, which compare an investment's performance to a benchmark index, absolute return evaluates the investment's performance solely based on the actual gains or losses. It doesn't consider whether the market as a whole is up or down.
- Risk Management: Absolute return is often used by investors and fund managers to assess the success of an investment strategy or a fund. It allows them to focus on the specific performance of an asset or portfolio rather than being influenced by market conditions.
- Asset Allocation: It can be a valuable tool for asset allocation in a diversified portfolio. By considering the absolute return of individual assets, investors can make informed decisions about how to balance their investments for the best overall performance.
Absolute Return Formula and Example
Calculating absolute return is quite simple. Let's say you invested Rs. 50,000 in a mutual fund on January 1, and its current value on December 31 is Rs. 60,000. To find the absolute return:
Absolute Return = [(Current Value - Initial Investment) / Initial Investment] * 100 |
Absolute Return = [(60,000 - 50,000) / 50,000] * 100 = 20%
So, your absolute return for the year is 20%.
Importance of Absolute Returns
Absolute returns hold significant importance in investment evaluations due to several reasons:
- Enhanced portfolio diversification: Absolute returns contribute to building a diversified investment portfolio aimed at achieving better overall returns. By focusing on absolute returns, investors can diversify their investments across various asset classes and securities, reducing the overall risk exposure of their portfolio.
- Short-term and Long-term potential: Absolute returns cater to investors with different time horizons, offering the potential for both short-term and long-term gains. While some investors seek faster returns in the short term, others opt for a longer investment horizon to maximize their overall returns.
- Resilience to market volatility: Absolute returns are less susceptible to the fluctuations and volatility of financial markets compared to relative returns. This resilience allows investors to maintain a more stable investment strategy and mitigate the impact of market uncertainties on their investment portfolios.
- Dynamic risk management: Absolute returns facilitate dynamic risk management strategies, enabling investors to adjust their investment allocations based on changing market conditions and risk profiles. This flexibility empowers investors to make informed decisions to safeguard their investment capital while pursuing attractive returns.
- Focus on positive returns: The primary objective of absolute returns is to generate positive investment returns irrespective of market conditions. This goal-oriented approach aligns with investors' expectations of achieving growth and preserving the value of their investment capital over time.
- Simplicity in calculation: Absolute returns offer a straightforward and easy-to-understand method of calculating investment performance. By comparing the initial investment with the final value, investors can quickly assess the absolute return generated by their investment, making it a simple and accessible metric for investment analysis.
When to use Absolute Return analysis?
Absolute return analysis becomes relevant when investors seek to embrace a certain level of risk in pursuit of the opportunity to attain significant returns, regardless of the timeframe involved.
Difference Between Absolute Return and Relative Return in Mutual Funds
Absolute return provides the actual gain or loss on your investment, while relative return compares your fund's performance to a benchmark index (Like Nifty). While absolute return is an exact measure, relative return gives you an idea of how well your fund performed compared to its peers or the market.
