What is the difference between absolute and relative return?
We often hear people talk about investment performance. You can consider the performance of your mutual fund in two basic ways: absolute and relative performance. One isn’t necessarily better than the other, but you must know when you should use one instead of the other.
Absolute performance means exactly that: absolute. It isn’t used to compare your investment performance with anything else. An investment down 50% is bad and will sometimes permanently impair your portfolio’s ability to recover over any meaningful time frame. This performance is looked at in a vacuum, not taking into account that everybody else’s portfolio was down the same amount or more. Absolute return analysis is typically good to use when assessing your portfolio’s performance in terms of a stated goal, such as paying for a college education. It doesn’t matter, and it doesn’t feel any better that your portfolio is down 50% and you can’t pay for college even though your peers’ portfolios are down 70%. You didn’t meet your goal and subsequently failed in properly planning for your goal.
Relative performance is an assessment versus some index, whether that index is a staple, such as the Dow Jones Industrials Average or the S&P 500 or even your Uncle Ted’s or neighbor’s portfolio performance. In terms of a mutual fund, the annual and semiannual report will typically track your fund’s performance versus an appropriate index for that investment. For example, a large-cap US stock fund will be compared with the S&P 500. Relative performance is a good tool to use to assess how your manager is doing compared with their peers. Let’s say your fund is up 10% for the year, but those of your peers are up 25% on the year. While the absolute performance of 12% is good, lagging their index by mid-teens is cause for further investigation.