What Is an Abnormal Return?
An abnormal return describes the unusually large profits or losses generated by a given investment or portfolio over a specified period. The performance diverges from the investments' expected, or anticipated, rate of return (RoR)—the estimated risk-adjusted return based on an asset pricing model, or using a long-run historical average or multiple valuation techniques.
Returns that are abnormal may simply be anomalous or they may point to something more nefarious such as fraud or manipulation. Abnormal returns should not be confused with "alpha" or excess returns earned by actively managed investments.
Key Takeaways
- An abnormal return is one that deviates from an investment's expected return.
- The presence of abnormal returns, which can be either positive or negative in direction, helps investors determine risk-adjusted performance.
- Abnormal returns can be produced by chance, due to some external or unforeseen event, or as the result of bad actors.
- A cumulative abnormal return (CAR) is the sum total of all abnormal returns and can be used to measuretheeffectlawsuits, buyouts, and other eventshave onstock prices.
Understanding Abnormal Returns
Abnormal returns are essential in determining a security or portfolio's risk-adjusted performance when compared to the overall market or a benchmark index. Abnormal returns could help to identify a portfolio manager's skill on a risk-adjusted basis. It will also illustrate whether investors received adequate compensation for the amount of investment risk assumed.
An abnormal return can be either positive or negative. The figure is merely a summary of how the actual returns differ from the predicted yield. For example, earning 30% in a mutual fund that is expected to average 10% per year would create a positive abnormal return of 20%. If, on the other hand, in this same example, the actual return was 5%, this would generate a negative abnormal return of 5%.
The abnormal return is calculated by subtracting the expected return from the realized return and may be positive or negative.
Cumulative Abnormal Return (CAR)
Cumulative abnormal return (CAR) is the total of all abnormal returns.Usually, the calculation of cumulative abnormal return happens over a small window of time, often only days. This short duration is because evidence has shown that compounding daily abnormal returns can create bias in the results.
Cumulative abnormal return (CAR) is used to measuretheeffectlawsuits, buyouts, and other eventshave onstock prices and is also useful for determining the accuracy ofassetpricing models in predicting the expected performance.
The capital asset pricing model (CAPM) is a framework used to calculate a security or portfolio's expected return based on the risk-free rate of return, beta, and the expected market return. After the calculation of a security or portfolio's expected return, the estimate for the abnormal return is calculated by subtracting the expected return from the realized return.
Example of Abnormal Returns
An investor holds a portfolio of securities and wishes to calculate the portfolio's abnormal return during the previous year. Assume that the risk-free rate of return is 2% and the benchmark index has an expected return of 15%.
The investor's portfolio returned 25% and had a beta of 1.25 when measured against the benchmark index. Therefore, given the amount of risk assumed, the portfolio should have returned 18.25%, or (2% + 1.25 x (15% - 2%)). Consequently, the abnormal return during the previous year was 6.75% or 25 - 18.25%.
The same calculations can be helpful for a stock holding. For example, stock ABC returned 9% and had a beta of 2, when measured against its benchmark index. Consider that the risk-free rate of return is 5% and the benchmark index has an expected return of 12%. Based on the CAPM, stock ABC has an expected return of 19%. Therefore, stock ABC had an abnormal return of -10% and underperformed the market during this period.
FAQs
In finance, an abnormal return is the difference between the actual return of a security and the expected return. Abnormal returns are sometimes triggered by "events." Events can include mergers, dividend announcements, company earning announcements, interest rate increases, lawsuits, etc.
What is an example of abnormal rate of return? ›
For example, earning 30% in a mutual fund that is expected to average 10% per year would create a positive abnormal return of 20%. If, on the other hand, in this same example, the actual return was 5%, this would generate a negative abnormal return of 5%.
How do you get abnormal returns? ›
Abnormal returns are common in finance and economics event studies, where you subtract the actual firm's stock market return from some benchmark (such as the average market return on that day or a predicted firm return based on a regression).
What defines abnormal risk and return? ›
Definition: Abnormal rate of return or 'alpha' is the return generated by a given stock or portfolio over a period of time which is higher than the return generated by its benchmark or the expected rate of return. It is a measure of performance on a risk-adjusted basis.
What is the daily abnormal return? ›
The daily abnormal return is computed by subtracting the predicted normal return from the actual return for each day in the event window. The sum of the abnormal returns over the event window is the cumulative abnormal return.
What is average abnormal returns? ›
2. Average abnormal returns are the sum of abnormal return (AR) of the newly included constituents over the study period divided by the number of newly included constituents (29 firms). 3. Abnormal returns are calculated as observed returns less the estimated expected return from the market model.
What is a real life example of internal rate of return? ›
IRR is also useful in demonstrating the power of compounding. For example, if you invest $50 every month in the stock market over a 10-year period, that money would turn into $7,764 at the end of the 10 years with a 5% IRR, which is more than the current 10-year Treasury (risk-free) rate.
What causes abnormal returns? ›
In finance, an abnormal return is the difference between the actual return of a security and the expected return. Abnormal returns are sometimes triggered by "events." Events can include mergers, dividend announcements, company earning announcements, interest rate increases, lawsuits, etc.
What is a negative abnormal return? ›
Abnormal Return/Excess Returns: The difference between the actual return and the expected return. It can be either positive (when the actual return is higher than expected) or negative (when the actual return is lower than expected).
What is an example of a risk-return? ›
For example, if the stock market as a whole loses value, chances are your stocks or stock funds will decrease in value as well until the market returns to a period of growth. Market risk exposes you to potential loss of principal, since some companies don't survive market downturns.
Abnormal returns are calculated by deducting the returns that would have been realized if the analyzed event had not taken place (normal returns) from the actual returns of the stocks. While the actual returns can be empirically observed, the normal returns need to be estimated.
What is buy and hold abnormal returns? ›
(1) Buy-and-hold abnormal return approach (BHAR)
Buy-and-hold is an investment strategy where an investor buys stocks and holds them for a long time. The BHAR grounds on this strategy and calculates abnormal returns by deducting the normal buy-and-hold return from the realized buy-and-hold return.
What is an abnormal return valuation? ›
The abnormal earnings valuation model is a method for determining a company's equity value based on both its book value and its earnings. Also known as the residual income model, it looks at whether management's decisions will cause a company to perform better or worse than anticipated.
What is an example of a negative rate of return? ›
An investment has a negative rate of return when it loses value over a measured time period. If, in the following year, the mutual fund described above decreases in value from $11,000 back to $10,000, its rate of return for that year is approximately negative 9%.
What is an example of a rate of return? ›
RoR on Stocks and Bonds
If the investor sells the stock for $80, their per-share gain is $80 - $60 = $20. In addition, they have earned $10 in dividend income for a total gain of $20 + $10 = $30. The rate of return for the stock is thus a $30 gain per share, divided by the $60 cost per share, or 50%.
What is an abnormal rate? ›
For athletic individuals, a normal resting heart rate may be as low as 40 to 60 bpm. Abnormal heart rhythms can be described as a heart beating too fast (above 100 bpm) or slow (below 60 bpm), a fluttering sensation in the chest area or the skipping of a heart beat.
