Abnormal Return

If you’ve dipped your toes into the world of investing, you’ve probably heard the term abnormal return pop up here and there. It might sound complex, but it’s a pretty straightforward concept that can help you make better investment decisions. In this post, we'll break it down in a way that makes sense, even if you’re not a finance expert.

What is Abnormal Return?


At its core, abnormal return refers to the difference between the actual return of an investment and the expected return. It’s that extra (or missing) chunk that shows up when things don’t go as predicted.

Here’s a quick breakdown:
  • Actual return is what you really earned (or lost) on an investment.
  • Expected return is what you thought you would earn, based on market trends, historical data, or a model like the Capital Asset Pricing Model (CAPM).
So, if you thought your investment would give you a 5% return but you ended up getting 10%, you’ve got an abnormal return of +5%. Nice, right? On the other hand, if you only got 2%, your abnormal return is -3%, which might sting a little.

What Causes Abnormal Returns?


There are several reasons an investment can yield an abnormal return, both positive and negative:
  1. Market Events: Unexpected events like a product launch, a merger, or even a global crisis can make a stock perform differently than expected.
  2. Company Performance: Maybe a company exceeded expectations by crushing its earnings report or fell short with bad news, affecting its stock price in ways that no one saw coming.
  3. Economic Indicators: Changes in interest rates, inflation, or other economic indicators can shift the market, causing abnormal returns.
  4. Investor Behavior: Sometimes, people get a little too excited (or scared) about a stock, causing prices to move in unexpected directions.

Types of Abnormal Return


There are actually a few different types of abnormal return that can show up in your portfolio. Let’s explore the various types of abnormal return so you can better understand what’s happening with your investments.

1) Positive Abnormal Return:
This is the kind of abnormal return everyone wants! A positive abnormal return means your investment made more money than you expected. It’s like ordering a pizza and finding an extra slice inside—it’s a nice little bonus. For example, if you thought you’d earn 5% on a stock but ended up with 8%, that extra 3% is your positive abnormal return. It’s the market’s way of saying, "You’re welcome."

2) Negative Abnormal Return:
On the flip side, a negative abnormal return is like finding out that extra slice of pizza is missing. Your investment didn’t do as well as you hoped, and that can sting a little. So, if you were expecting a 6% return but only got 2%, that missing 4% is your negative abnormal return. It's the market saying, "Sorry, not today."

3) Cumulative Abnormal Return (CAR):
Sometimes it’s not about just one day’s performance but how your investment behaves over time. Cumulative abnormal return (CAR) is when you add up all the abnormal returns over a period to see how your investment did during a specific event, like a product launch or a big market shift. For example, if a company announces a major merger, you’d track the abnormal returns over a few weeks to see how the market reacted as the news unfolded. CAR lets you see the bigger picture.

4) Market-Adjusted Abnormal Return:
Sometimes it’s not enough to just know how your investment did—you want to know how it did compared to the rest of the market. A market-adjusted abnormal return compares your stock’s performance to the broader market (like the S&P 500 or any index). If your stock earned 7% while the market earned 5%, your market-adjusted abnormal return is +2%. It’s a nice way to see if your stock is truly outperforming or if everything is just moving up together.

5) Risk-Adjusted Abnormal Return:
Investing is all about balancing risk and reward. A risk-adjusted abnormal return considers how much risk you took on to get that extra return. Because let’s face it: getting high returns is great, but not if you had to take on a huge amount of risk to get there. One way people calculate risk-adjusted returns is with something called the Sharpe Ratio (don’t worry, no need to get technical here). The idea is to measure how much extra return you got for every bit of risk you took.

How to Calculate Abnormal Return?


Here is the formula to calculate abnormal returns:

Abnormal Return = Actual Return − Expected Return

For example, if you invested in a stock and the market expected it to return 6%, but the actual return was 9%, here’s your abnormal return:

9% − 6% = 3%

You got an extra 3% more than expected. That's a nice bonus!

Why Should You Care About Abnormal Returns?


Abnormal returns can be a great way to figure out if your investment is doing better or worse than it should be based on the current market. It gives you insight into whether a stock’s performance is due to overall market trends or something specific to that investment.

Here’s why abnormal returns matter:
  • Performance Evaluation: Investors use abnormal returns to gauge whether an investment has truly added value or if the results were in line with market expectations.
  • Understanding Events: Big events like earnings reports or new product launches can cause abnormal returns. Tracking these helps you see if the market responded the way you thought it would.
  • Risk Awareness: A stock with a lot of negative abnormal returns might indicate underlying problems or higher risks. On the flip side, consistent positive abnormal returns can be a signal that the investment is performing better than expected.

The Flip Side: Risks of Chasing Abnormal Returns


While positive abnormal returns can be exciting, it’s important not to get too carried away. Just because a stock is performing better than expected right now doesn’t mean it always will. The market has a way of balancing itself, and chasing high returns without understanding the risks can sometimes lead to disappointment.

Think of it this way: Abnormal returns are like finding extra cash in your jacket pocket. It’s great when it happens, but it’s not something you should count on every time you put on the jacket!

Conclusion:
Knowing about abnormal returns can give you a little extra insight into your investments. It helps you understand whether your portfolio is working the way it should or if there are surprises – both good and bad – that you need to take into account. But remember, it’s just one tool in your investor toolkit. The key is to stay balanced, be aware of the risks, and make decisions based on the bigger picture.