Understanding Abnormal Return
Abnormal return refers to investment returns that deviate significantly from the expected or normal rate of return.
It can be either excessively high or low, indicating a departure from the usual performance of an investment or fund.
Such abnormal returns are typically temporary and may be caused by abnormal market conditions or fraudulent activities by the entity managing the investment.
It’s important to distinguish abnormal returns from concepts like Alpha and excess returns, which are attributed to the skill and performance of investment managers.
On the other hand, Cumulative Abnormal Returns (CAR) represent the sum of all abnormal returns and are used to monitor the impact of external factors on stock prices.
Significance of Abnormal Returns
Abnormal return plays a crucial role in evaluating the performance of a portfolio in comparison to the broader market or benchmark index.
It helps assess and recognize the risk-adjusted expertise of a portfolio manager, indicating whether investors are adequately compensated for the assumed investment risk.
It’s important to note that an abnormal return is not synonymous with a negative return, as it can be positive or negative.
It represents the difference between actual and expected returns. Abnormal returns serve as a valuable metric for evaluating returns about market performance.
Abnormal Return as an Evaluation Metric
By analyzing abnormal returns, you can assess the risk-adjusted performance of a portfolio relative to market norms and benchmark indexes.
This enables you to determine whether your investments provide adequate compensation for the risk incurred.
Calculating abnormal returns involves subtracting anticipated returns from actual returns.
Cumulative Abnormal Return (CAR)
Cumulative Abnormal Return (CAR), as mentioned earlier, represents the sum of abnormal returns over a specific period.
It significantly allows investors to assess an asset’s or security’s performance over a defined period since abnormal returns during short time frames can be distorted.