Excess Returns
Understanding Excess Returns As It Relates To Investing
As savvy investors, we understand that gauging the performance of our investments is crucial for success. Excess returns offer a comprehensive measure for this, helping us to distinguish between mere average results and truly exceptional performance.
Definition and Overview
Excess returns, fundamentally, represent the profits generated by an investment above and beyond a predetermined benchmark.
Typically, this benchmark could be a relevant market index, such as the S&P 500 for U.S. equities. When we speak of an investment yielding excess returns, it indicates that it has outperformed the market average, factoring in the level of risk taken.
Measuring Excess Returns
Accurately measuring excess returns involves computing the difference between the return of our investment and the return of the benchmark.
For portfolios particularly, a common metric we use is the Information Ratio, which evaluates the excess returns of a portfolio relative to the returns of a reference index, adjusted for risk.
Calculation Example |
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Portfolio return |
Benchmark return |
Excess Return |
The calculation is straightforward: If our portfolio returns 10% while the benchmark only returns 7%, then our excess return is 3%.
Importance in Stock Investing
Excess returns are pivotal in stock investing. They serve as a robust indicator of investment performance and the investment manager’s skill.
Generating consistent excess returns signals effective investment choices that add genuine value to our portfolio, beyond what’s expected from market movements alone. This distinction is critical in distinguishing between luck and skill in the investment process.
Our focus on excess returns helps us strive to ensure our investments are not just keeping pace with market trends, but actually capitalizing on opportunities to maximize wealth for us and our clients.