An abnormal return is a portfolio’s or investment’s uncharacteristically high earnings or losses over a certain time period. The performance deviates from the rate of return (RoR) anticipated for the investments, which is the estimated risk-adjusted return calculated using an asset pricing model, a long-term historical average, or a variety of valuation methods.
Returns that are unusual could just be aberrant or they could be a sign of fraud or other criminal activity. It’s important to distinguish between abnormal returns and “alpha,” or excess returns from actively managed investments.
When evaluating a security or portfolio’s risk-adjusted performance in comparison to the wider market or a benchmark index, abnormal returns are crucial. On a risk-adjusted basis, abnormal returns could be used to determine a portfolio manager’s skill. Additionally, it will show whether investors were fairly compensated for the degree of investment risk they assumed.
Positive or negative returns are both considered abnormal. Simply said, the figure shows how the actual returns compare to the expected yield. For instance, a positive anomalous return of 20% would result from earning 30% in a mutual fund with an expected average annual return of 10%. On the other hand, if the actual return in this case was 5%, this would result in a negative abnormal return of 5%.