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What are Abnormal Returns?

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  • Written By: Mary McMahon
  • Edited By: O. Wallace
  • Last Modified Date: 31 October 2016
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In the financial world, abnormal returns are actual returns which vary from the expected returns on securities and other financial instruments. Abnormal returns can be positive or negative, and they are a common concern for investors and other people involved in financial markets. Financial analysts spend a great deal of time and energy carefully predicting the performance of overall financial markets and specific financial instruments to reduce the risk of negative abnormal returns.

In a simple example of abnormal returns, a financial market might be expected to grow by 10%, and a specific stock within that market might grow by 20%, generating an abnormal return of 10%. Conversely, the stock could grow by five percent, creating an abnormal return of five percent below the expected return. Abnormal returns can involve a wide variety of markets and financial instruments, and they can vary radically, from a few percentage points to a very dramatic and notable difference.

A number of calculations go into the process of developing expected returns. Considerations include the history of a market's performance, ongoing political issues, and general economic trends. Calculating expected returns can be highly challenging, especially with large and complex markets which can be very vulnerable to a variety of events. Abnormal returns can occur because of events which skew the market, ranging from a run on a particular stock which causes the value to rise to a natural disaster which causes a decline in stock values.

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Consistently negative abnormal returns are a cause for concern because they suggest that expected returns are not being calculated correctly, and that a particular financial instrument is experiencing some volatility. Regularly positive returns can also be a cause for concern, as they may suggest that a financial instrument is overvalued and at risk of collapsing in value, or that falsification of performance records is occurring. This is especially true when returns follow a consistent upward trend with little variation in growth; a financial instrument will rarely grow by the same amount each year, for example, and abnormal returns which follow suspiciously regular patterns can be a sign of financial shenanigans.

Sometimes, an analysis of abnormal returns can explain why they occurred. Catastrophic economic events, sudden political changes, and environmental issues like droughts can all impact the performance of financial markets and individual instruments within those markets. At other times, the causes behind variations between expected and actual returns cannot be easily explained; markets can be fickle, and sometimes they behave highly erratically.

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honeybees
Post 4

I have been involved in investments for many years and have seen many people get burned when they try to trade stocks based on what an expected return might be.

There are people who are very successful at making short term investments, but it is something I have lost too much money at and prefer a more conservative approach.

When you have a buy and hold strategy, an abnormal return once in awhile isn't as much of an issue as it can be with a shorter time frame.

I am also very cautious when it comes to consistently high return investments. The ride is good as long as the stock keeps giving you those good returns. It

just seems like once they take a fall, the prices go down much faster than they went up.

If you haven't taken some profits along the way, the value of your investment can change very quickly. Every person has to find a strategy and plan they feel comfortable with when it comes to evaluating investment returns.

bagley79
Post 3

My dad has been a farmer all of his life, and keeps a close watch on his investments. He also closely watches the commodities markets because he is so closely involved with many of these markets.

There are a lot of issues that are factored in to a stocks returns, but catastrophic events and weather really make a lot of the commodity markets extremely volatile.

He probably couldn't give you a text book answer for an abnormal return definition, but could give you many personal examples he has seen over the years.

We live in the Midwest and when a drought drastically affects the yield on the corn prices, you can count on some abnormal returns on the price of corn in the fall.

andee
Post 2

I realize that financial analysts spend a lot of time trying to predict what the returns of any given stock will be.

It just seems like they are way off on their predictions a lot of times, and it usually it affects me in a negative way.

After taking more than my share of losses with these investments, I am now more of a long term investor. Abnormal stock returns also affect long term investments, but over time, they seem to balance out.

SarahSon
Post 1

I am a fairly active stock trader and have seen how abnormal returns can really make a big difference on earnings returns results.

If you are in an investment for the short term, this can really have a big impact on what you do with this investment.

If the returns are higher than expected, you might want to take advantage of it and cash in on some profits. If the returns are lower than what they thought, this isn't so easy.

Sometimes I wait it out, and other times if the financial picture looks bleak, I will take my losses and sell.

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