What is an 'Abnormal Return'

An abnormal return is a term used to describe the returns generated by a given security or portfolio over a period of time that is different from the expected rate of return. The expected rate of return is the estimated return based on an asset pricing model, using a long run historical average or multiple valuation.

BREAKING DOWN 'Abnormal Return'

Abnormal returns are important in determining a security's or portfolio's risk-adjusted performance when compared to the overall market or a benchmark index. Abnormal returns could help to determine a portfolio manager's skill on a risk-adjusted basis and whether investors were adequately compensated for the amount of risk assumed.

An abnormal return can be either a good or bad thing, as it is merely a summary of how the actual returns differ from the predicted return. For example, earning 30% in a mutual fund that is expected to average 10% per year would create a positive abnormal return of 20%. If, on the other hand, the actual return was 5%, this would generate a negative abnormal return of 5%.

Calculating Abnormal Return Using CAPM

The capital asset pricing model (CAPM) is a framework used to calculate a security's or portfolio's expected return based on the risk-free rate of return, beta and the expected market return. After a security's or portfolio's expected return is calculated, the abnormal return could be calculated by subtracting the expected return from the realized return. The abnormal return may be positive or negative, depending on the performance of the security or portfolio over the specified period.

For example, assume that the risk-free rate of return is 2% and the benchmark index has an expected return of 15%. An investor holds a portfolio of securities and wishes to calculate his portfolio's abnormal return during the previous year. The investor's portfolio returned 25% and has a beta of 1.25, when measured against the benchmark index. Therefore, given the amount of risk assumed, the portfolio should have returned 18.25%, or (2% + 1.25 x (15% - 2%)). Consequently, the abnormal return during the previous year was 6.75%, or 25% - 18.25%.

The same calculations could be done for a security. For example, stock ABC returned 9% and has a beta of 2, when measured against its benchmark index. Assume that the risk-free rate of return is 5% and the benchmark index has an expected return of 12%. Based on CAPM, stock ABC has an expected return of 19%. Therefore, stock ABC has an abnormal return of -10% and underperformed the market during this period.

RELATED TERMS
  1. Capital Asset Pricing Model - CAPM

    Capital Asset Pricing Model is a model that describes the relationship ...
  2. Risk-Free Return

    Risk-free return is the theoretical return attributed to an investment ...
  3. Mean Return

    1. In securities analysis, it is the expected value, or mean, ...
  4. Gross Rate of Return

    Gross rate of return is the total rate of return on an investment ...
  5. Annualized Total Return

    Annualized total return gives the yearly return of a fund calculated ...
  6. Annual Return

    Annual return is the compound average rate of return for a stock, ...
Related Articles
  1. Investing

    Explaining Expected Return

    The expected return is a tool used to determine whether or not an investment has a positive or negative average net outcome.
  2. Financial Advisor

    Measure Your Portfolio's Performance

    Measuring the success of your investment solely on the portfolio return may leave you blindsided to risk. Learn how to evaluate your investment return.
  3. Investing

    How to calculate required rate of return

    The required rate of return is used by investors and corporate-finance professionals to evaluate investments. In this article, we explore the various ways it can be calculated and put to use.
  4. Financial Advisor

    A Deeper Look At Alpha

    The Jensen index helps investors compare realized returns to what should've been achieved.
  5. Tech

    CAPM vs. Arbitrage Pricing Theory: How They Differ

    Both project the expected rate of return given the level of risk assumed, but they consider different variables.
  6. Investing

    How to calculate your investment return

    How much are your investments actually returning? The method of calculation can make a significant difference in your true rate of return.
  7. Investing

    How to Evaluate Stock Performance

    Learn how to evaluate stock performance. While what you look for in a stock could be different from another person, the way you analyze performance is the same.
  8. Investing

    Understanding Quantitative Analysis Of Hedge Funds

    Learn how hedge fund performance quantitatively requires metrics such as absolute and relative returns, risk measurement, and benchmark performance ratios.
RELATED FAQS
  1. How can I calculate the expected return of my portfolio?

    Understand the components of the equation used to calculate the expected return of an investor's portfolio. Learn why the ... Read Answer >>
  2. How does market risk affect the cost of capital?

    Find out how market risk directly affects the total cost of capital, including how to use the capital asset pricing model ... Read Answer >>
  3. How is the Capital Asset Pricing Model (CAPM) represented in the Security Market ...

    Learn about the capital asset pricing model and the security market line and how the model is used in the calculation and ... Read Answer >>
  4. What is the formula for calculating the capital asset pricing model (CAPM) in Excel?

    Find out more about the capital asset pricing model (CAPM) and the formula for calculating it in Microsoft Excel. Read Answer >>
Trading Center