Abnormal return definition
In the world of stock market trades, the accepted abnormal return definition is the financial performance by a single stock or portfolio of stocks that varies from the market average. An abnormal return can be positive or negative, depending on whether the stock outperformed or underperformed the average market performance. This abnormal return definition refers to financial gains and losses measured against an actual index, rather than an artificial or hypothetical measure. The market average is usually defined as the performance of a broad-based index; the Standard & Poor’s 500 is an example of a widely-followed index in the United States, while other areas may index their market average to their own national markets for purposes of determining abnormal returns.
Abnormal Return Calculation
Initial abnormal return calculations are deceptively simple, and consist of subtracting the index performance (usually expressed as a negative or positive percentage) from the individual stock or portfolio’s performance. This provides a crude measure of the stock’s performance at a specific time, but does not take into consideration fluctuations that naturally occur over a given period. To account for these normal variations, the cumulative abnormal return calculation is defined as the percentage sum of all abnormal returns over a defined period of time. Thus, the simple abnormal return formula can be expressed as:
• (performance of individual stock or portfolio) – (index performance) = (abnormal return)
And the cumulative abnormal return formula is expressed as:
• (sum of all daily abnormal returns of individual stock or portfolio) – (sum of all daily index performances) = (cumulative abnormal return) In practice, several other factors are used to derive the cumulative abnormal return result; these weighting factors are used to eliminate statistically insignificant results and gains or losses clearly derivative of outside market factors.
Importance of Abnormal Returns
Abnormal returns are usually associated with an event or market change that directly affects the stock or portfolio in question. Mergers, initial public offerings, and other major news or market events often provide the impetus for abnormal returns. For instance, news of a major legal action against a company can drive its stock downward significantly, causing its losses to far exceed the general market performance as measured by one of the leading indexes. This significant loss is an abnormal return, and a negative one; if the company’s stock loses 10% of its overall value, while the market index increased by 5%, then we can determine the extent of this abnormal return by use of the abnormal return formula explained above. The losses sustained by the company are 10%, and the market improved by 5%; thus, negative 10% minus the 5% positive gain of the market index produces an abnormal return calculation of negative 15%, an even more significant loss than it first appeared. By factoring in the market performance, the true extent of losses and potential losses can be more closely determined by market analysts and investors, allowing a more accurate picture of the stock’s worth and current viability. Cumulative abnormal return calculations are usually intended to provide analysts with longer-term information about the effects of a major event on a stock’s price, and can also serve as a measure of the stock’s overall stability, allowing a more accurate assessment of the stock’s true worth.