What is Abnormal Return?
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 Does Abnormal Return Work?
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 = RActual – RNormal
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 Does Abnormal Return Matter?
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.