Excess returns are almost always a good thing, although sometimes they can signify that something is very off in your projected calculations. Calculating excess returns is a critical piece of effective bookkeeping and reviewing your investment practices. In the simplest terms, excess returns are the amount that an investment earns above a specific benchmark, which may be your projection, someone else's projection or some other kind of benchmark. As an investor, you should understand this definition and other terms surrounding this concept and be able to calculate excess returns.
Excess Returns Definition
Excess returns are returns that occur above and beyond what was projected for an investment, a portfolio or another asset, explain the writers at the Corporate Finance Institute. In that way, they're a good thing. It means you have extra money or assets above what you expected to have at a given point in time. This money is also sometimes called alpha.
You may have used a formula to calculate an investment's expected rate of return. If you have that number, you can calculate the excess return, as the excess return will be the amount over and above that expected rate.
Even if you do not have or your business does not use expected rates of return, you can use a different benchmark. You should naturally have some expectations for your investments, even if you don't calculate expected rates of return yourself.
Excess Returns Formula
To determine the rate of excess returns, you'll use a formula called the Capital Assets Pricing Model (CAPM). That formula is: Ra = Rf + B(Mr-Rf), where Ra = expected return on a security, Rf = risk-free rate, B = Beta of the security and Mr = expected return of the market.
You can adjust the CAPM formula for excess return rates as follows: Er = Rf + B(Mr-Rf) - Tr, explain the writers for The Strategic CFO. All of the mathematical symbols are the same, except in addition, Er = excess rate of return and Tr = actual or total return from the security.
As always, remember your order of operations when doing math like the excess returns formula. You calculate equations within parentheses first, followed by exponents, multiplication, division and lastly, subtraction and addition.
Excess Returns vs. Risk Premiums
Excess returns and risk premiums are related but certainly not the same. The risk premium is actually the expected excess return, rather than the actual excess return.
Sometimes, especially on higher-risk investments, investors hope that taking a chance will pay off. Meanwhile, the excess return is often calculated on top of risk premiums.
Frequently Asked Questions
You might be wondering, are excess returns and excess market returns the same thing? They're close, but not the same thing. The excess market return is how much a stock makes above the return of the U.S. Treasury for that year. For example, if the U.S. Treasury grows by 2 percent in a given year, but your stock increased by 10 percent, then the excess market return of that stock is 8 percent.
What, exactly, is the excess return of a portfolio? It's essentially the same as excess return, except it's looking at an entire portfolio of stocks or investments rather than just one. Investors also might wonder what excess return indices are. These are just simple ways to think about the metrics by which you measure excess return or other data about your investments. When you look at a chart measuring changes in value, you're looking at indices.
Finally, you might want to know whether you calculate excess return in Excel. Fortunately, you can. You'll need to use a specific type of sheet and plug in the formulas, but Excel is a powerful tool for calculating just about everything having to do with stocks and keeping tabs on your own. There are lots of good tutorials online if you need extra help.
Consider also: Can Dividends Be Paid in Excess of Retained Earnings?