Abnormal return is the unusual profits from set securities or portfolios over a specific period of time. It is also known as Alpha/excess returns. The main element is that the performance of the five securities is different from the anticipated rate of return (RoR) on an investment. The anticipated rate of return is the expected return bases on an asset pricing model combined with historical average or multiple valuation.
Abnormal returns are important when it comes to determining a security’s or Portfolio’s performances in comparison with the overall Market or benchmark index. It helps in determining and identifying a portfolio manager’s skill on a risk-adjusted Basis. It also illustrates whether investors have availed the compensation for the amount of investment risk that was assumed.
It is important to remember that abnormal return doesn’t mean just a negative return. It can be either positive or negative. The end figure is a summary of the difference between actual returns from the predicted return.
Abnormal returns are a useful valuation tool for comparing returns to market performance.
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Ramesh is expecting a 10% return on his investment based on a historical average. But the actual return, he receives is 20% of his investment. This is a positive abnormal return of 10% since his predicted return was lesser than the actual return. However, if Ramesh receives only 5% on a predicted return of 10%, he would avail a negative abnormal return of 5%.
Cumulative abnormal return is the total sum of all abnormal returns. It is useful in determining the accuracy of the asset pricing model in predicting estimated performance.