What are Abnormal Returns?
Definition: Abnormal returns is defined as the difference between the expected value of the security’s contribution to the total value of your investment and its actual value at settlement. Typically, these unanticipated gains are not included in earnings estimates.
The amount of deviation from observed market prices in a specified period is called an abnormal return. It represents an additional loss at the time when expected prices have been discounted at least in part.
Abnormal returns can be considered normal for a particular security or market when the deviation from the price line does not exceed the limit established by the statistical confidence interval around the estimate of the actual returns. However, abnormal returns may also be viewed as undesirable characteristics of an investment portfolio even when normal market returns are expected.
The concept is as follows, a single stock or a portfolio of securities is purchased, and its price is estimated using information and assumptions about future events and trends.
Sales on this [stock/portfolio] are made at some point in the future; if and when this occurs, such sales are recognized as abnormal returns and recognized in the financial statements as a decrease in the argument between actual and expected sale proceeds (i.e., unrealized gains). Abnormal returns may be short-term in nature, such as for a short period, or longer-term in nature, such as for a set period that occurs after such abnormal return has been recognized.
Understanding Abnormal Returns
Abnormal returns are an important component of successful investment risk management. They determine the difference between an investment’s expected return and its actual return. Those returns can be either positive or negative, depending on how the investment was valued and performed. Their purpose is to identify which securities or investments are rewarding investors without putting sufficient value on their positions. By identifying objectively fair prices for assets, investors can ensure that their portfolio grows over time even if various market conditions influence investment trends.
The use of abnormal returns in securities trading can result in unrealistic gains or losses. Abnormal returns can inflate or deflate the market price, depending on the investor’s perspective, leading to short-term trading losses or gains.
Abnormal Returns can be interpreted as:
- Positive abnormal returns: When a trader thinks that their trades will earn him more money than he is due. If this occurs, it may be because he has overvalued his options.
- Negative abnormal returns: It occurs when you expect to earn less than the actual amount earned.
Abnormal returns are useful if you want to monitor your portfolio’s price action. They allow you to see what impact investing strategy has on your portfolio. This can help you understand whether the risk-return tradeoff is worth it or not.
Put simply; abnormal returns are generally used to track ongoing investments or combinations of assets. This could include a portfolio or investment that has generated returns over time, less than the benchmark but still has enough value to be held in a portfolio.
This could be an asset class, such as government bonds, stocks, real estate, private equity, or anything else within the asset management industry that generates returns that aren’t necessarily typical for that asset class.
Abnormal returns can also help investors detect trends and avoid mispricing in their portfolios by comparing performance against a certain benchmark.
Cumulative Abnormal Return (CAR)
The concept of cumulative abnormal return is used in risk management measures for financial markets. The most commonly used CAR measure is the average abnormal return, which is simply the average of all the abnormal returns during a specified period. Abnormal returns can be calculated for several asset classes, including stocks, bonds, derivatives, and currencies.
A cumulative abnormal return is calculated as the difference between estimated sales for a given period and actual sales. This is a useful performance measure for investors due to the impact a particular investment may have on the market.
However, it is the best of these measures only to be integrated into a model predicting future sales. In practice, the best CAR is obtained by estimating future sales using a combination of information currently available and information about historical sales patterns. The combination of these estimates provides a reasonable confidence interval around the actual sales.
Example of Abnormal Returns
Imagine you’ve just invested $50 and will get back an average of 10% over the life of the investment. At the end of the 10 years, you decide to sell your stock at an average price of $100. The market is saying that it’ll take you 4 years to earn back that $1,000. But in reality, it could take much longer because, in 4 of the 10 years, it could take a conservative investor 10 times as long to earn back that one-to-one return as an aggressive trader who recently made a few bucks shorting stocks.