What is Abnormal Return? And Why Every Investor Should Care
As an investor, you’ve probably heard the term abnormal return thrown around, especially when analysts and financial advisors are talking about how a stock or portfolio is performing. But what does it actually mean, and why should you care? In short, abnormal returns are the difference between the actual return of an asset and the expected return, based on the broader market or a specific benchmark. But there’s a lot more to it than just numbers and fancy terminology.
So, let’s break down abnormal return in simple terms and see how it can help you assess whether your investment strategy is hitting or missing the mark. Plus, we’ll throw in a bit of humor, because, let’s face it—understanding investment concepts shouldn’t feel like a dry history lecture.
What Exactly Is Abnormal Return?
In the world of investing, abnormal return refers to the difference between an investment’s actual return and the expected return based on some benchmark or market index. The expected return is typically calculated using models that account for the overall market performance, the asset’s risk, and various economic factors.
If your stock or portfolio earns more than expected, you’ve earned positive abnormal returns. If it earns less than expected, you’ve got negative abnormal returns. Think of it like this:
- Positive abnormal return = you beat the market (or at least your expectations), and your investment outperformed what it was supposed to do. You’re winning.
- Negative abnormal return = you missed the mark, and your investment lagged behind where it was supposed to be. Oops, better luck next time.
Why Should You Care About Abnormal Returns?
Abnormal returns are useful because they help you measure how well your investments are performing relative to the broader market or a specific benchmark. They give you insight into whether your portfolio is outperforming, underperforming, or simply tracking with the market.
For example, imagine you invested in a stock, and based on a risk model or market index, you expected it to return 8% over the past year. However, the stock actually returned 12%. You’ve earned positive abnormal return (4% more than expected). Congratulations, you’re making your money work harder than anticipated. Maybe it’s time to update your LinkedIn profile with “Investment Guru” as your new title.
But what if the stock only returned 4%? Now you’re facing a negative abnormal return (4% less than expected). That’s not the end of the world, but it’s a reminder that not all investments follow a straight line to success. And sometimes, the market just has a mind of its own.
How Is Abnormal Return Calculated?
Now, let’s talk numbers, but we’ll keep it light. Calculating abnormal return involves comparing the actual return of an asset to its expected return, which is often derived from a benchmark index (like the S&P 500 for stocks) or a financial model like the Capital Asset Pricing Model (CAPM).
Here’s the basic formula:Abnormal Return=Actual Return−Expected Return\text{Abnormal Return} = \text{Actual Return} – \text{Expected Return}Abnormal Return=Actual Return−Expected Return
- Actual Return: This is how much your investment actually earned over a specific period. This could be the stock’s price change, including dividends, or any other form of return.
- Expected Return: This is the return you would expect based on market conditions, risk factors, or a benchmark index. This is often calculated using models like the CAPM, which estimates the expected return based on the risk-free rate, the asset’s beta (which measures its volatility relative to the market), and the market’s overall return.
Let’s run through a simple example. Say you bought a stock at $100, and it ended up at $110 a year later. That’s a 10% return ($110 – $100 = $10 profit).
Now, let’s assume that based on your research, market trends, and a benchmark like the S&P 500, you expected a 6% return. Using the formula:Abnormal Return=10%−6%=4%\text{Abnormal Return} = 10\% – 6\% = 4\%Abnormal Return=10%−6%=4%
That means you earned a positive abnormal return of 4%. Nice job—you did better than expected!
Abnormal Returns and Active vs. Passive Investing
If you’re an active investor, you’re probably hoping for positive abnormal returns—the kind that make your portfolio look like a star on a stock screen. After all, active investing relies on finding opportunities that outperform the broader market.
On the other hand, passive investors who use strategies like index funds don’t necessarily expect abnormal returns. They’re content with market returns—they aim to mirror the performance of the market (like an index fund tracking the S&P 500). In their case, a return that matches the market is a win. But even passive investors occasionally get the itch to see a little extra performance, which is why some funds occasionally promise a little “extra” on top of the market average.
Here’s the twist: most actively managed funds struggle to consistently generate positive abnormal returns over the long term, especially after accounting for fees. Studies have shown that while some funds outperform the market for a short period, over the long haul, many underperform once the costs and risks are factored in. So, while you might be aiming for big gains, sometimes it’s worth considering whether the juice is worth the squeeze. (Sorry, no easy answers here!)
Why Abnormal Returns Aren’t Always the Full Story
As an investor, you can’t always hang your hat on abnormal returns alone. While they’re useful in assessing performance, they don’t tell the whole story. Sometimes a stock can outperform the market, but there may be factors like excessive risk-taking or a one-time event that led to the gain. It’s like winning the lottery—you might be happy, but you’re not about to base your retirement plan on pure luck, right?
Similarly, a negative abnormal return doesn’t necessarily mean that your strategy was flawed. The market can be unpredictable, and some factors—like geopolitical events, macroeconomic shifts, or even a global pandemic (yes, we’ve all been there)—can impact returns unexpectedly. The key is to keep an eye on long-term trends and consistent performance, rather than getting too hung up on short-term fluctuations.
The Role of Abnormal Returns in Evaluating Fund Managers
For investors, abnormal returns can be a key tool in evaluating the performance of mutual funds or hedge funds. If a fund manager consistently generates positive abnormal returns, you might be tempted to invest more, believing their strategy has a certain magic touch.
But don’t be too quick to pull the trigger. Past performance isn’t always a guarantee of future results—especially if the manager is relying on high levels of risk or a handful of lucky bets. When evaluating fund managers, consider not only the size of their abnormal returns but also the consistency of their performance and the risk-adjusted return (how much risk was involved to achieve those returns). After all, you don’t want to put your money in the hands of someone who only beats the market when the stars align.
Conclusion: Abnormal Return—The Good, the Bad, and the Meh
Abnormal returns are a crucial concept in investing because they help you gauge whether your investments are performing above or below expectations. Positive abnormal returns mean you’re ahead of the game; negative abnormal returns mean you’re lagging behind. It’s that simple (kind of).
But keep in mind that abnormal returns don’t tell you everything. While they’re useful for measuring relative performance, they don’t reveal the full picture of risk or long-term sustainability. And if you’re aiming for consistent gains, remember that it’s not just about hitting one home run—it’s about making smart, informed decisions over time.
So, the next time you see the term abnormal return, you’ll know that it’s a signal to either pat yourself on the back or think about how you can tweak your strategy. Either way, it’s a good excuse to take a moment and evaluate whether your investments are living up to your expectations—or if it’s time to head back to the drawing board.