Definition
Abnormal return, in finance, refers to the excess returns earned by a security or portfolio over the expected return. The expected return is typically gauged by a suitable benchmark such as an overall market index. An abnormal return can be either positive, indicating the investment outperformed the market, or negative, indicating it underperformed.
Key Takeaways
- Abnormal Return is a term used in finance and investing that refers to the excess returns that an investment or a portfolio has generated, beyond the expected return. It is essentially the difference between the actual return and what would have been expected based on the risk profile and market performance.
- This can occur due to many factors such as an unexpected earnings announcement, a change in economic policy, or a sudden fluctuation in the market. It’s an important concept in event studies, where researchers study how a specific event affects the value of a firm.
- Abnormal returns can be either positive, indicating that the investment outperformed market expectations, or negative, indicating the investment performed worse than expected. These returns are used to assess the financial effectiveness of proposed corporate events, or the success of investment strategies, allowing investors and portfolio managers to adjust accordingly.
Importance
The finance term ‘Abnormal Return’ is important because it helps investors measure the effectiveness of their investment strategies by comparing them against the expected returns. It refers to the difference between an asset’s actual return and the expected return, given the asset’s level of risk and the performance of the market as a whole.
It is a critical tool used to assess the value generated by the management policies of businesses or companies. When the abnormal return is positive, it indicates that the investment decision was profitable beyond the expected rate of return, showcasing the high efficiency of the implemented strategy.
Conversely, a negative abnormal return indicates underperformance. As such, understanding and interpreting abnormal returns are essential for investors and management alike as it aids in optimizing future investment decisions.
Explanation
Abnormal return, in finance, serves as a critical indicator of an investment’s performance, relative to an appropriate benchmark, such as a market index. This measure provides specific and detailed insights on how an investment deviates from the expected return, taking into account factors like risk and market movements.
Investors and financial analysts utilize abnormal returns to evaluate the effectiveness of investment strategies and make informed decisions. For instance, if a particular asset or a portfolio considerably outperforms or underperforms the expected return delivered by the market, it will produce a positive or negative abnormal return, respectively.
As a result, by assessing and analyzing the degree of abnormal return, investors can examine if potential anomalies or specific events cause excellent or poor performance. It hence plays an important role in portfolio management, asset pricing tests, event studies, and risk management.
Examples of Abnormal Return
Abnormal returns from Corporate Mergers & Acquisitions: When a corporation announces its plan to acquire or merge with another company, this generally leads to an unexpected jump or drop in their stock prices. For instance, when Facebook announced its acquisition of WhatsApp, Facebook’s share price rose by a significant margin, resulting in an abnormal return.
Earnings Announcement: Companies disclose their quarterly or annual earnings through earnings announcements. These announcements can lead to abnormal returns as the actual earnings might be higher or lower than what the investors predicted. For example, when Apple released its quarterly report in January 2020 and beat expectations considerably, the company’s shares spiked, demonstrating abnormal returns.
Product Launch: When a company launches a new product, it often leads to abnormal returns. For example, when Tesla introduced its Model S vehicle, its stock price increased significantly more than its typical average return, resulting in an abnormal return.
Frequently Asked Questions about Abnormal Return
1. What is an Abnormal Return?
An abnormal return refers to the earnings generated by a given security or portfolio that exceed or fall below their expected return. This deviation can be both positive and negative and is directly related to market volatility.
2. How is Abnormal Return calculated?
Abnormal return is calculated by subtracting the expected return from the actual return. For the expected return, you can use an appropriate industry benchmark or an asset pricing model like the CAPM.
3. What does a positive Abnormal Return indicate?
A positive abnormal return indicates that the investment has underperformed compared to the expected return.
4. How do Abnormal Returns affect portfolios?
Abnormal Returns can significantly affect portfolios. They can indicate whether a portfolio’s returns are due to smart investment decisions or market movements. Furthermore, large abnormal returns can sometimes indicate more risk.
5: Can Abnormal Returns be negative?
Yes, abnormal returns can be negative. Negative abnormal returns usually indicate that an investment has underperformed compared to the forecasted or expected return.
Related Entrepreneurship Terms
- Alpha
- Market Efficiency
- Risk-Adjusted Performance
- Event Study
- Capital Asset Pricing Model (CAPM)
Sources for More Information
- Investopedia: A comprehensive source of financial information, including a description and examples of abnormal returns.
- Corporate Finance Institute: Offers educational articles about various finance terms including abnormal return.
- Zacks Finance: Provides insightful articles and tips about investing and finance including abnormal returns.
- MarketWatch: A finance website that provides up-to-date news and information about the market, finance theories including abnormal returns.
