What Does It Mean to Have an Abnormal Return?
Over a given period, an abnormal return reflects the exceptionally significant profits or losses achieved by a certain investment or portfolio. The investment’s performance differs from its expected, or anticipated, rate of return (RoR)—the estimated risk-adjusted return calculated using an asset pricing model, a long-run historical average, or various valuation approaches.
Abnormal returns could just be aberrant, or they could indicate something more sinister, such as fraud or manipulation. “Alpha” or excess returns earned by actively managed investments are not to be confused with abnormal returns.
Abnormal Returns An Overview :
When comparing a security or portfolio’s risk-adjusted performance to the entire market or a benchmark index, abnormal returns are critical. On a risk-adjusted basis, abnormal returns could assist detect a portfolio manager’s expertise. It will also show if investors were fairly compensated for the amount of investment risk they took on.
A positive or negative anomalous return is possible. The graph simply shows how the actual returns deviate from the expected yield. For example, earning 30% in a mutual fund that is projected to return 10% annually would result in a positive anomalous return of 20%. If, on the other hand, the real return in this case was 5%, the result would be a negative abnormal return of 5%.
Cumulative Abnormal Return (CAR)
The total of all anomalous returns is called cumulative abnormal return (CAR). Typically, the cumulative anomalous return is calculated over a short period of time, often just a few days. Because data has indicated that compounding daily anomalous returns can lead to bias in the results, the duration is kept short.
The cumulative abnormal return (CAR) is a metric that is used to assess the impact of lawsuits, buyouts, and other events on stock prices, as well as the accuracy of asset pricing models in anticipating expected performance.
The capital asset pricing model (CAPM) is a framework for calculating the expected return of a securities or portfolio based on the risk-free rate of return, beta, and projected market return. After calculating the expected return of a security or portfolio, the anomalous return is estimated by subtracting the expected return from the realised return.
Example of Abnormal Returns.
An investor has a stock portfolio and wants to know what the portfolio’s abnormal return was the prior year. Assume that the risk-free rate of return is 2% and that the benchmark index has a 15% projected return.
When compared to the benchmark index, the investor’s portfolio returned 25% and had a beta of 1.25. As a result, the portfolio should have returned 18.25 percent, or (2 percent + 1.25 x (15 percent – 2 percent) given the level of risk assumed. As a result, the anomalous return for the prior year was 6.75 percent, ranging from 25 to 18.25 percent.
A stock holding can benefit from the same calculations. When compared to its benchmark index, stock ABC, for example, returned 9% and had a beta of 2. Consider that the risk-free rate of return is 5%, whereas the benchmark index has a 12-percent projected return. Stock ABC is anticipated to return 19 percent according to the CAPM. As a result, stock ABC had an anomalous return of -10% during this time period, underperforming the market.
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