The abnormal return on a security or portfolio is not the same as the expected return. So what is Abnormal return and why earning an Abnormal return is difficult? If you do not know, this article is for you.
What is abnormal return?
Abnormal returns, also known as "excess returns", are unanticipated profits (or losses) generated by a security/stock. Abnormal returns are measured as the difference between the actual return an investor earns on an asset and the expected return usually predicted using the CAPM equation.
Abnormal returns can be positive or negative. Positive abnormal returns are realized when actual returns are greater than expected returns. According to the CAPM equation, negative abnormal returns (or losses) occur when actual returns are lower than expected.
Why earning an abnormal return is difficult?
According to the efficient market hypothesis, investors are unlikely to earn abnormally high returns. Because the price of an asset includes all available information that could affect the price of the product.
How to Calculate Abnormal Return?
Calculate expected return. we can use the capital asset pricing model
(CAPM). Here are the equations for the model:
Er = Rf + β (Rm – Rf)
where Er = the expected return on the security and Rf = the risk-free rate, usually the interest rate on a government security or savings deposit rate, β = the risk factor of the security or portfolio compared to the market, Rm = the market rate of return or an appropriate index for a given security, such as the S&P 500.
Once we already have the expected return, we calculate the abnormal return by subtracting the same from the actual return. Abnormal returns will be negative when a portfolio or security underperforms expectations. Otherwise, it will be positive or equal to zero, as the case may be.
I hope this article will help you to learn what is Abnormal return and why earning an Abnormal return is difficult. Abnormal returns allow investors to track the performance of an individual asset or portfolio of assets relative to a benchmark, usually set using the CAPM equation. By benchmarking market returns, abnormal returns allow investors to gauge the true extent of profits and losses.
