What is an abnormal return?

Last Updated: 6 Mar 2023

Abnormal returns — also popularly known as ‘alpha returns’ or ‘excess returns’ — are unexpected returns from a security or a portfolio, that are not congruent with market returns. Instead, it is the result of investor expertise.

The meaning of abnormal return can be either positive or negative. This figure is simply a summary of how the actual returns differ from the predicted returns. Positive abnormal returns are realized when the actual returns are higher than the expected returns. Negative abnormal return, or otherwise, an abnormal loss occurs when the actual returns are lower than expected.

How it works

The abnormal return on investment is calculated as RAbnormal = RActual – Rnormal

A normal return on any investment is a forecasted return or can be the return on a specific index, such as the Dow Jones, or the S&P 500 through the same period. For example, the normal return for a mutual fund may be forecasted (say, 10%) for a given year based on historical performance. Alternatively, it might be the 10% return on the S&P 500 index in a given year. In the latter case, it is said that a given investment experienced a given abnormal return relative to the S&P 500.

The importance of abnormal return

Such returns enable investors to track the performance of individual assets or portfolios against specific benchmarks, usually determined using the CAPM equation. By using market returns as a benchmark, abnormal returns allow investors to measure the true magnitude of profits and losses.

The numbers are also used to measure the financial impact of mergers, litigation, product launches, organizational changes, and other events that affect a company’s stock price.

Examples of abnormal returns

Cumulative Abnormal Return (CAR)

Cumulative abnormal return is the sum of all abnormal returns over a period. These are usually calculated in a short time frame, often days. This short period is due to evidence that compounding daily abnormal returns can show biased results.

CAR is used to measure the impact of lawsuits, acquisitions, and other events on stock prices. It is also useful in determining the accuracy of asset pricing models in predicting expected performance.

The Capital Asset Pricing Model (CAPM) is a framework for calculating the expected rate of return for a security or portfolio based on the risk-free rate of return, beta, and expected market rate of return. After calculating the security or portfolio’s expected return, an estimate for the abnormal return is worked out by subtracting the expected return from the realized return.

Final word

Abnormal return meaning is simply the unanticipated profits or losses generated by a security or stock. The presence of abnormal returns helps investors determine the risk-adjusted performance. Such returns can be produced by chance, by some external or unforeseen event, or as the result of some poor performances.

• Suppose a particular stock DDC earns a 20% return in a given year. Analysts expected DDC to experience a return of 10% for that year. The (positive) abnormal rate of return for DDC is:
• 20% Actual return – 10% Normal (projected) return = 10% Positive Abnormal Return
• Significant financial announcements may also lead to abnormal returns.For example, the stock price of Spotify (NASDAQ: SPOT) fell in early February 2020 on the news that it incurred far more losses than expected.

Frequently Asked Questions

Is Alpha an abnormal return?

Ans: Alpha (α) is used in finance as a measure of performance, to describe an investment strategy’s ability to beat the market. Alpha returns are also often referred to as ‘excess return’ or ‘abnormal rate of return’ referring to the idea that markets are efficient, and so there is no way to systematically earn returns that exceed the market as a whole.

What are buy and hold abnormal returns?

Ans: The buy-and-hold abnormal return approach (BHAR) is an investment strategy wherein an investor buys a stock and holds it for a long period. Based on this principle, the BHAR calculates abnormal returns by deducting the normal buy-and-hold return from the realized buy-and-hold return.