Understanding Abnormal Returns: A Guide to Investment Performance

Abnormal return, also known as “excess return,” refers to the unanticipated profits (or losses) generated by a security/stock. Abnormal returns are measured as the difference between the actual returns that investors earn on an asset and the expected returns that are usually predicted using the CAPM equationCapital Asset Pricing Model (CAPM)The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between expected return and risk of a security. CAPM formula shows the return of a security is equal to the risk-free return plus a risk premium, based on the beta of that security.

Abnormal returns can be positive or negative. Positive abnormal returns are realized when actual returns are greater than expected returns. Negative abnormal returns (or losses) occur when the actual return is lower than what was expected, according to the CAPM equation.

Cumulative Abnormal Return (CAR)

Cumulative Abnormal Return (CAR) refers to the sum of abnormal returns over a given period of time. It allows investors to measure the performance of an assetTypes of AssetsCommon types of assets include current, non-current, physical, intangible, operating, and non-operating. Correctly identifying and or securitySecurityA security is a financial instrument, typically any financial asset that can be traded. The nature of what can and can’t be called a security generally depends on the jurisdiction in which the assets are being traded. over a specific period of time, especially since abnormal returns over short windows tend to be biased.

Abnormal Returns – Importance

Abnormal returns allow investors to track the performance of an individual asset or a portfolio of assets relative to a certain benchmark, which is usually set using the CAPM equation. By accounting for the market return as a benchmark, abnormal returns allow investors to measure the true extent of profits and losses.

The figures are also used to measure the financial impact of mergers, lawsuits, product launches, organizational changes, and other events that affect the price of a company’s stock.

Examples

• In some cases, stock prices tend to fluctuate following the social media activity of a company’s top management. For example, in 2018, Tesla’s share price dropped when CEO Elon Musk tweeted that he was considering taking the company private at $420 a share, and Tesla’s stock (NASDAQ: TSLA) was suspended from trading for a few days.
• Financial announcements also produce abnormal returns. For example, in early February 2020, Spotify’s (NASDAQ: SPOT) stock price fell upon the announcement of a loss that was much larger than projected.

Related Readings

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