What Is an Abnormal Return?

An abnormal return assesses an investment's performance by contrasting its actual return against the anticipated return based on an industry benchmark like the S&P 500 index.

Oct 16, 2024 at 03:15 pm

What Is an Abnormal Return?

An abnormal return is the difference between the actual return on an investment and the expected return. It is often used to measure the performance of an investment manager or to compare the performance of different investments.

1. Calculating Abnormal Returns

Abnormal returns are calculated using the following formula:

Abnormal Return = Actual Return - Expected Return

2. Actual Return

The actual return is the real return paid out to an investor on their investment.

3. Expected Return

The expected return is the value of how much one's investment should be expected to increase or decrease, characterized as a percentage. It is typically calculated using a benchmark, such as the S&P 500 index.

4. Interpreting Abnormal Returns

A positive abnormal return indicates that the investment outperformed the benchmark. A negative abnormal return indicates that the investment underperformed the benchmark.

5. Applications of Abnormal Returns

Abnormal returns are used in a variety of applications, including:

• Performance measurement: To evaluate the performance of investment managers.
• Investment comparison: To compare the performance of different investments.
• Risk analysis: To identify investments that have the potential to generate above-average returns.

6. Assumptions of Abnormal Returns

The calculation of abnormal returns relies on several assumptions, including:

• The benchmark used to measure expected return is accurate.
• The risk of the investment is accurately accounted for.
• The investment follows normal distribution and mean-variance pattern.

7. Limitations of Abnormal Returns

Abnormal returns can be affected by a number of factors, including:

• Data errors: Inaccurate data can lead to misleading abnormal returns.
• Survivorship bias: The use of data only from surviving investments can overstate abnormal returns.
• Measurement error: The use of different benchmarks can lead to different abnormal returns.