Abnormal Return Meaning
Over a particular time period, an abnormal return reflects the exceptionally significant profits or losses achieved by a certain investment or portfolio. The investment’s performance differs from its expected, or anticipated, rate of return (RoR)—the estimated risk-adjusted return calculated using an asset pricing model, a long-run historical average, or various valuation methodologies.
Abnormal returns could just be aberrant, or they could indicate something more sinister, such as fraud or manipulation. The terms “abnormal returns” and “alpha,” or excess returns earned by actively managed investments, should not be conflated.
Abnormal Returns: Further Overview
When comparing security or portfolio’s risk-adjusted performance to the entire market or a benchmark index, abnormal returns are critical. On a risk-adjusted basis, abnormal returns could help to determine a portfolio manager’s expertise. It will also show if investors were fairly compensated for the amount of investment risk they took on.
A positive or negative anomalous return is possible. The graph is simply an overview of how actual returns compare to the expected yield. For example, earning 30% in a mutual fund that is projected to return 10% annually would result in a positive anomalous return of 20%. If, on the other hand, the real return in this same example was 5%, the result would be a 5% negative anomalous return.
Abnormal Return on a Cumulative Basis (CAR)
The total of all anomalous returns is known as the cumulative abnormal return (CAR). The calculation of the cumulative anomalous return is usually done over a short period of time, often just a few days. Because data has indicated that compounding daily anomalous returns can produce bias in the results, the timeframe is kept short.
The cumulative abnormal return (CAR) is used to determine the accuracy of asset pricing models in anticipating expected performance and to measure the impact of lawsuits, buyouts, and other events on stock prices.
The capital asset pricing model (CAPM) is a framework for calculating the expected return of a securities or portfolio based on the risk-free rate of return, beta, and projected market return. After calculating the expected return of a security or portfolio, the anomalous return is estimated by subtracting the expected return from the realized return. Returns that are out of the ordinary are an example of abnormal returns.
An investor has a stock portfolio and wants to know what the portfolio’s abnormal return was the prior year. Assume that the risk-free rate of return is 2% and that the benchmark index has a 15 percent projected return. When compared to the benchmark index, the investor’s portfolio returned 25% and had a beta of 1.25. As a result, the portfolio should have returned 18.25 percent, or given the level of risk assumed. As a result, the anomalous return for the prior year was 6.75 percent, ranging from 25 to 18.25 percent.
The same calculations can be used to determine the value of stock ownership. When compared to its benchmark index, stock ABC, for example, returned 9% and had a beta of 2. Consider that the risk-free rate of return is 5%, whereas the benchmark index has a 12-percent projected return. Stock ABC is anticipated to return 19 percent according to the CAPM. As a result, stock ABC had an anomalous return of -10% during this time period, underperforming the market.
Importance of Abnormal Returns
Investors may use abnormal returns to monitor the performance of a single asset or a portfolio of assets against a benchmark, which is often defined using the CAPM equation. 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, organisational changes, and other events that influence the price of a company’s shares are also measured using these numbers.
Cumulative Abnormal Return (CAR)
The aggregate of anomalous returns over a certain time period is referred to as Cumulative Abnormal Return (CAR). It enables investors to assess an asset’s or security’s performance over a fixed length of time, which is useful since anomalous returns during short periods of time are prone to bias.
