Abnormal Return

An Abnormal Return is a term used to describe 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.

Abnormal returns can be either positive or negative. 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, 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. Returns that are abnormal may simply be anomalous or they may point to something more nefarious such as fraud or manipulation.

A Cumulative Abnormal Return (CAR) is the sum 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. CAR is used to measure the effect lawsuits, buyouts, and other events have on stock prices and is also useful for determining the accuracy of asset pricing models in predicting the expected performance.

Abnormal returns are essential in determining a security or portfolio's risk-adjusted performance when compared to the overall market or a benchmark index. They could help to identify a portfolio manager's skill on a risk-adjusted basis and illustrate whether investors received adequate compensation for the amount of investment risk assumed. Abnormal returns should not be confused with "alpha" or excess returns earned by actively managed investments.

Abnormal returns enable investors to determine the real magnitude of earnings and losses by using the market return as a baseline. Mergers, litigation, product launches, organizational changes, and other events that influence the price of a company's shares are also measured using these numbers.

Abnormal returns, also known as excess returns, are a critical aspect of finance. They provide a tool for investors to quantify to what degree an investment has outperformed. Excess returns can be calculated across a wide number of different investment scenarios, making it a simple yet powerful tool. Excess returns are essentially the performance of an investment that exceeds what is expected based on its risk and market conditions. An excess return serves as a quantitative measure of an investment's ability to outperform, providing investors with insights into the effectiveness of their strategies. The calculation of excess returns is often straightforward and involves subtracting the expected return of an investment from the actual return. In finance, investors use models like the Capital Asset Pricing Model (CAPM) or the Arbitrage Pricing Theory (APT) to predict the expected return. The goal is to compare this expected return with the actual return achieved, helping us assess how well the investment performed compared to what the market expected.