Abnormal Return

Updated on April 29, 2024
Article byShraddha Sureka
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Abnormal Return?

Abnormal Return is defined as the increase or decrease in the returns with respect to the estimated profits or losses. It is the difference between the actual return for a stock or a portfolio of securities and the return based on market expectations in a selected time period.

What Are Abnormal Returns

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Abnormal Return (wallstreetmojo.com)

Abnormal return is a key performance measure on which a portfolio manager or an investment manager is gauged. It is confused with excess returns, which is completely unjustified as the latter is concerned with implementing good strategies to uplift returns. On the contrary, abnormal increase or drop in returns indicate manipulation.

Key Takeaways

  • Abnormal returns represent the deviation between an investment’s actual and expected returns. Investors utilize them to assess an investment’s performance relative to the overall market or a benchmark.
  • Abnormal returns can be either positive or negative. Positive abnormal returns indicate that the investment has outperformed expectations, while negative abnormal returns indicate underperformance.
  • Abnormal returns play a crucial role in investment decision-making and portfolio management. They provide valuable insights into the effectiveness of investment strategies and the overall efficiency of financial markets, aiding investors in making informed choices.

Abnormal Return Explained

Abnormal return is most important, a measure which can help in gauging the performance of the portfolio manager and the correctness of his insights of market movement. This further gives asset management companiesAsset Management CompaniesAn Asset Management Company (AMC) refers to a fund house, which pools money from various sources and invests the same in purchasing capital on behalf of their investors.read more ground to base the performance-based bonuses or commissions of their portfolio managers and a justification of the same for client understanding.

Also, as it can be positive or negative, it can indicate when the divergence from the market index is not fruitful and should be narrowed, for the better performance of the portfolio.

When one wants to judge whether security or a group of securities have over or underperformed its peers, they need to figure out on what parameters to judge such performance. Therefore, the investment community has come up with such measures as the Abnormal return to articulate how much of such performance can be attributed to the skills of the portfolio manager and his scheme of asset allocation Asset AllocationAsset Allocation is the process of investing your money in various asset classes such as debt, equity, mutual funds, and real estate, depending on your return expectations and risk tolerance. This makes it easier to achieve your long-term financial goals.read more and stock selection.

When  the performance of a portfolio is to be compared, a proportional market index is used as a benchmark over which we calculate the excess. For example, if one wants to compare a portfolio of financial sector stock in India, one may use the Nifty Bank Index, while if they have a portfolio of large-cap stocksLarge-cap StocksLarge-cap stocks refer to stocks of large companies with value, also known as the market capitalization of 10 billion dollars or more, and these stocks are less risky than others and are stable. They also pay a good dividend and return, and it is the safest option to invest.read more in the US, then they can have the S&P 500 as the benchmark.

Abnormal returns, as the name suggest, indicate a change in returns to beyond an expected level. A positive resultant, when the difference between expected and actual returns are figured out, is positive, it indicates the returns are greater than the expected returns. On the contrary, if the resultant is negative, it reflects the returns are lower than expected figures.

Though it can be either profits or losses, the former being more appealing, this drastic variation might reflect some manipulation or fraud in dealing with the datasets. This could either be a voluntary or involuntary act. Hence, the inputs must be checked. A minor variation is always expected by the entities, but a huge variation leads to doubts.

Formula

The formula that helps in the accurate abnormal return calculation is mentioned as follows:

Abnormal Return Formula

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Abnormal Return (wallstreetmojo.com)

It is represented as below,

Abnormal Return Formula = Actual Return – Expected Return

How to Calculate?

To calculate the Expected returnCalculate The Expected ReturnThe Expected Return formula is determined by applying all the Investments portfolio weights with their respective returns and doing the total of results. Expected return = (p1 * r1) + (p2 * r2) + ………… + (pn * rn), where, pi = Probability of each return and ri = Rate of return with probability. read more, we can use the Capital Asset Pricing ModelCapital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more (CAPM). The following is the equation for the model:

Er = R+ β (Rm – Rf)

Here, Er = Expected return in the security, Rf = risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more, generally the rate of a government security or savings deposit rate, β= risk coefficient of the security or the portfolio in comparison to the market, Rm= Return on the market or an appropriate index for the given security such as S&P 500.

  • Once we already have the expected return, we subtract the same from the actual return to calculate Abnormal return.
  • When the portfolio or security has underperformed the expectations, the Abnormal return will be negative. Otherwise, it will be positive or equal to zero, as the case may be.

As per the prudent approach, it is better to take a look at the risk-adjusted returnRisk-adjusted ReturnRisk-adjusted return is a strategy for measuring and analyzing investment returns in which financial, market, credit, and operational risks are evaluated and adjusted so that an individual may decide whether the investment is worthwhile given all of the risks to the capital invested.read more. This is in keeping with the concept of risk tolerance because otherwise, the portfolio manager may deviate from the IPS goals and take up highly risky investments to generate Abnormal returns.

In the case of multiple periods, it may be helpful looking at the standardized returns to see if the portfolio is constantly beating the benchmark. If this is the case, then the standard deviation of the Abnormal return will be lower, and then we can say that the portfolio manager has genuinely made a better stock selection than the benchmark.

Examples

Let us consider the following instances to understand the abnormal return definition better and also check how it works:

Example 1

You can download this Abnormal Return Excel Template here – Abnormal Return Excel Template

You can download this Abnormal Return Excel Template here – Abnormal Return Excel Template

Suppose we are given the following information. Use this information to calculate abnormal return.

  • Rf: 4%
  • Rm: 12%
  • Beta of the Portfolio: 1.8
  • Beginning Value of Portfolio: $50,000
  • Ending Value of Portfolio: $60,000

Solution:

Step 1: Calculation of Er of Portfolio

Abnormal Return Example 1.1

So we have calculated the expected return using the CAPM approach as follows:
Er = Rf + β (Rm – Rf)
Er = 4+1.8*(12% – 4%)
Er = 18.40%

The above calculation is done before the period under consideration starts, and it is only an estimation. When this period expires, we can calculate the actual return based on the market value at the beginning and the end of the period.

Step 2: Calculation of Actual Return can be done as follows,

Abnormal Return Example 1.2

Actual Return = Ending Value – Beginning Value/Beginning Value*100
=$60000 – $50000/$50000 * 100
=20.00%

Step 3: Abnormal Return Calculation.

Abnormal Return Example 1.3

=20.00% – 18.40%
=1.60%

Example 2

In October 2022, a study was published that stated that the stocks purchases by senators lead to abnormal returns. The study revolved around the information asymmetry, which according to the researchers, was one of the reasons behind the market responding positively against the Senators’ purchase. The researchers selected a range of sample stocks purchased by the US Senate. The sample stocks were purchased between 2012 and 2020. The pattern suggested that the firms offering those stocks witnessed huge returns near the time it was disclosed.

Importance

Abnormal return is the unanticipated returns generated from the investments made. Such returns hold vital significance in the market as they help identify discrepancies. Let us have a look at the importance in a pointwise format:

CAR is calculated by taking the sum of the abnormal returns over a specific period.

Frequently Asked Questions (FAQs)

1. What are the applications of abnormal return analysis?

The applications of abnormal return analysis include assessing the performance of investment portfolios, evaluating the impact of specific events or news on stock prices, and conducting event studies to measure the effects of corporate actions or announcements on stock returns. In addition, it helps to identify the excess return generated by an investment strategy or to measure the impact of specific events on stock performance.

2. What are some limitations of abnormal returns analysis? 

Limitations of abnormal returns analysis include the difficulty in accurately estimating expected returns, the presence of market inefficiencies and noise that can affect returns, the challenge of selecting appropriate benchmarks or indices for comparison, and the potential for data mining and false discoveries. 

3. How can abnormal returns be interpreted in event studies? 

Abnormal returns in event studies are interpreted by comparing the observed returns around an event (such as an earnings announcement or merger announcement) with the expected returns based on a benchmark or market index. Positive abnormal returns may indicate that the event positively impacted the stock price, suggesting a favorable market reaction. Conversely, negative abnormal returns may suggest a negative market reaction to the event. 

Recommended Articles

This has been a guide to what is Abnormal Return. Here, we explain the concept along with its formula, how to calculate it, examples, and importance. You can learn more from the following articles –