Abnormal Return

By ADAM BARONE
Updated Apr 25, 2019

What Is an Abnormal Return?

An abnormal return describes the unusual profits generated by given securities or portfolios over a
specified period. The performance is different from the expected, or anticipated, rate of return (RoR)
for the investment. The anticipated rate of return is the estimated return based on an asset pricing
model, using a long run historical average or multiple valuations.

Why Abnormal Returns Are Important

Abnormal returns are essential in determining a security's 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 which 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%.

Cumulative Abnormal Return

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 measure the effect of lawsuits, buyouts, and
other events have on stock prices. Cumulative abnormal return (CAR) is also useful for determining
the accuracy of asset pricing model in predicting the expected performance.

The capital asset pricing model (CAPM) is a framework used to calculate a security's 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's or portfolio's expected return, the estimate for the abnormal return is by
subtracting the expected return from the realized return. The abnormal return may be positive or
negative, depending on the performance of the security or portfolio over the specified period.

KEY TAKEAWAYS

 An abnormal return describes the unusual profits generated by a specific security or portfolio
over a period of time.
 Abnormal returns, which can be either positive or negative, determine risk-adjusted
performance.
 A cumulative abnormal return is the total of all abnormal returns.
 CAR is used to measure the effect of lawsuits, buyouts, and other events have on stock prices.

Real World Example

Assume that the risk-free rate of return is 2% and the benchmark index has an expected return of 15%.
An investor holds a portfolio of securities and wishes to calculate his portfolio's abnormal return
during the previous year.
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 to 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 capital asset pricing
model (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.

Reference:
https://www.investopedia.com/terms/a/abnormalreturn.asp