Excess Returns
Understanding Excess Returns
In our exploration of the financial markets, we often encounter the term “excess returns.” Understanding it can be pivotal for us as we navigate investment decisions and measure performance against relevant benchmarks.
Concept of Excess Returns
Excess returns refer to the amount by which an investment’s performance outpaces a specific benchmark or risk-free rate.
We use this metric to determine the additional value an investor receives from taking on greater risk than that of a virtually risk-free asset, like a U.S. Treasury Bill.
Excess returns offer a glimpse into the effectiveness of an investment strategy and help us measure our skill and market knowledge against general market movements.
Calculating Excess Returns
To calculate excess returns, we take the percentage gain or loss of an investment and subtract the return of the benchmark index or risk-free rate.
For example, if we have a stock that returns 10% over a period and a Treasury bill in the same period returns 2%, our excess return is:
Excess Return = Investment Return - Benchmark Return
In this case:
Excess Return = 10% - 2% = 8%
This 8% serves as a quantifiable performance indicator above what we would have earned with minimal risk involved.
Benchmark Indices
We select benchmark indices to serve as our yardstick for performance. Common benchmarks include major indices like the S&P 500 or the Russell 2000.
They help us track how well our investments are doing compared to the market as a whole or specific sectors.
An easy way to visualize the importance of choosing the right benchmark is through the following table:
| Investment Type | Possible Benchmark |
|---|---|
| Large-cap stocks | S&P 500 |
| Small-cap stocks | Russell 2000 |
| International stocks | MSCI EAFE |
| Bond investments | Barclays Aggregate |
Choosing the appropriate benchmark is crucial; comparing our large-cap stock returns to a small-cap benchmark might not give us an accurate sense of our performance.
Each investment type should be assessed against a comparable index to ensure we are making an apples-to-apples comparison.