Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Abnormal Return

What it is:

Abnormal return, also known as "alpha" or "excess return," is the fraction of a security's or portfolio's return not explained by the rate of return of the market. Instead, it is a result of the expertise of the investor.

How it works (Example):

An abnormal return is referred to as either a positive abnormal return or a negative abnormal return, depending on where the actual return falls in relation to the normal return. The abnormal return on an investment is calculated as follows:

RAbnormal = RActualRNormal

The normal return on an investment can be a forecasted return or it can be the return on an index, such as the Dow Jones or the S&P 500 during the same period. For instance, the normal return for an investment portfolio, such as a mutual fund, might be a forecasted return of 10% for a given year based on past performance; or the 10% (example) return on the S&P 500 index in a given year. In the latter case, it is said that a given investment experienced a given abnormal return relative to the S&P 500.

To illustrate, suppose a stock XYZ experiences a 20% return in a given year. Analysts expected XYZ to experience a return of 10% for that year. The (positive) abnormal rate of return XYZ is:

20% actual return – 10% projected return = 10% positive abnormal return

XYZ experience a positive abnormal return of 10% during in that year.

Why it Matters:

An investment's abnormal return, positive or negative, measures how it performed over a given period of time. In this respect, it is useful to investors as a valuation tool and for comparing returns to market performance.