Abnormal Returns Explained: Definitions, Causes, and Examples

What Is an Abnormal Return?

An abnormal return is one that deviates from an investment's expected return. The presence of abnormal returns, which can be either positive or negative, helps investors determine risk-adjusted performance. Abnormal returns may result from chance, unforeseen events, or bad actors. Cumulative abnormal return (CAR) sums all abnormal returns and measures how events like lawsuits or buyouts affect stock prices.

How to Evaluate Abnormal Returns

Abnormal returns are key in assessing a security or portfolio's risk-adjusted performance against the market or a benchmark index. Abnormal returns could help to identify a portfolio manager's skill on a risk-adjusted basis. It shows if investors received enough compensation for the risk they took.

An abnormal return can be positive or negative, summarizing how actual returns differ from predicted yields. 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, in this same example, the actual return was 5%, this would generate a negative abnormal return of 5%.

What is Cumulative Abnormal Return (CAR) and Why It Matters

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.

CAR measures how lawsuits, buyouts, and other events impact stock prices and checks asset pricing models' accuracy in predicting expected performance.

The capital asset pricing model (CAPM) calculates a security or portfolio's expected return using the isk-free rate, beta, and market return. After the calculation of a security or portfolio's expected return, the estimate for the abnormal return is calculated by subtracting the expected return from the realized return.

Real-World Examples of Abnormal Returns

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

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 - 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 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.

The Bottom Line

Abnormal return is the difference between the realized return and the expected return on an investment, which can be positive or negative. Abnormal returns indicate risk-adjusted performance and can result from random events or misconduct such as fraud. They can be calculated with models like the Capital Asset Pricing Model (CAPM) for expected returns. Cumulative abnormal returns (CAR) can measure the impact that lawsuits or buyouts have on stock prices. Investors seeking to evaluate performance and risk should understand and analyze abnormal returns.