Learn to invest

A Beginners Guide to Residual Return

As many of you know, the stock market is an interesting beast. Predicting an unpredictable market is not a simple task for even the smartest of investors; predicting an unpredictable market in the 10th chapter of “Unprecedented Times” comes with a whole different set of challenges. 

Many of us followed the GameStop saga during the peak of the Covid lockdowns, with most of us rooting for the little guys instead of the big shots. Since then, the idea that the stock market is a tool for the rich to get richer is a thing of the past. 

This isn’t your parents’ Wall Street, anymore. 🙌

Because of this new wave of investors, Front is constantly trying to come up with innovative ways to improve our app and educate our users. The lesson at this time is: High returns don’t always equal success, but the return after risk. Let’s add some math to make things more interesting: 

Let us introduce you to a concept known as Residual Return. This calculation is how much return you are generating, based on the market risk adjusted (or for more seasoned investors, the Sharpe Ratio) you are taking on a specific stock compared to the overall performance of the S&P 500(a proxy to measure the overall performance of the U.S stock market).

Basically, it is calculating if you are a good stock picker and if your picks are doing better than the S&P 500.The residual return equation goes a little something like this:

Residual return = stock return – (Benchmark return * beta)

The results of this calculation will tell you if the stock you own yielded a higher or lower return based on the overall performance of the S&P 500, while also taking into account the risk factor of said stock. The purpose of the residual return is to determine if your assets are over or under performing the benchmark, which in our case is the S&P 500. 

Now that we brought the math to the table, let’s breakdown some critical terms to solving this equation:

  • Stock return refers to the profit you have made over a period of time. For this example, we are using 1 year.
  • Benchmark return is what you are comparing the performance to – in this case we are using the S&P 500. 
  • Beta is the covariance of the stock and the market. A beta of 2 means if the market goes up by 1% the stock will go up by 2% (beta(2)*1%) and if the market goes down by 1% the stock would go down by 2%. Beta represents how much market risk the stock has.
    •  Example: the beta of Coca-Cola is 0.58.
      • The beta of any stock can be found by performing a simple google search.

Okay, so now that we understand the basic principles of residual return, let’s get to work. 

🚨WARNING: I am going to do math again! 

Let us look back to the formula:

Residual return = stock return – (Benchmark return * beta)

Now, time to calculate 🤓

For this example, we are going to use the assets of my hypothetical friends Frank and Diane.

Residual return

When we plug these numbers into our equation, we get the residual return. 

Frank– Residual return= 8%-(10% * 0.58) = 8% – 5.8%
Residual Return = 2.2% 

Diane– Residual return= 20% – (10% * 2.18) = 20% – 21.8%
Residual Return= -1.8%

Frank has a positive residual return of 2.2%, while Diane’s residual is a negative 1.8%.

So, What Does This Mean? 

You can think of residual returns as a way of telling whether your stock’s returns were higher or lower than they were expected to be, or in theory “should have” been based on its market derived risk level.
Technically,  a positive residual indicates that your stock is outperforming the S&P 500 and generating more return with a calculated risk rather than a blind gamble.  

A stock with a lower or negative residual will likely provide safer return (defensive stocks) and a stock that’s defensive in nature is one that tends to do better than others in an overall bearish environment.

In turn, residual return data can prove vital to investors of all levels to educate them on historical performance as well as calculated risk. When building your portfolio or investing for “sport”, the main objective is to profit, right? So, why not use all the tools at your disposal? 

But, where do you find these tools so that you don’t have to bust out your Texas Instrument and composition notebook that you haven’t touched since 11th grade? 

The calculation is waiting for you in the Front App!

Within the Front App, you can not only connect ALL your assets in one place, view portfolios of your favorite investors and get in depth portfolio analysis; You will also be able to view your Front Score, which includes metrics such as ESG, Asset Health, and Diversification. Going forward it will also calculate Residual Return and give you even more insights into your portfolio! 

At Front, we fully believe that smarter tools can make smarter investors!

See where your portfolio can take you! ✌️💖🚀

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