What Is 'Abnormal Rate of Return'

An abnormal rate of return, also known as an excess return, is the difference between an asset's actual and expected returns. In other words, it is the excess return earned or lost by an investment compared to the market average or benchmark. An abnormal rate of return is considered abnormal because it differs from the expected or average rate of return for the market or industry.

Investors use abnormal returns to measure the performance of a particular investment or portfolio. If an investment's abnormal return is positive, it indicates that it has performed better than the expected or average rate of return. A negative abnormal return indicates that the investment has performed worse than expected or the average rate of return.

There are two types of abnormal returns: positive and negative. A positive abnormal return indicates the investment's outperformance compared to the market average or benchmark. It suggests that the investor made a profitable investment decision, resulting in a higher return than the expected or average rate of return. Conversely, a negative abnormal return indicates that the investment underperformed compared to the market average or benchmark, resulting in a lower return than the expected or average rate of return.

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Abnormal returns are essential for investors to evaluate investment decisions and portfolio performance. Investors can use abnormal returns to assess investment strategies' effectiveness and identify profitable investment opportunities. The goal of any investment is to achieve a return that is higher than the market average or benchmark, and abnormal returns help investors to determine if their investments are meeting this objective.

Calculating abnormal returns involves comparing an asset's actual return to the expected or average rate of return. The expected or average rate of return is determined based on the asset's risk and the market's overall return. A risk-adjusted benchmark, such as the Sharpe ratio or the Treynor ratio, is used to determine the expected rate of return.

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In addition to measuring investment performance, abnormal returns are also used in academic research to study financial markets' efficiency. The efficient market hypothesis suggests that all information available in the market is reflected in an asset's price, making it impossible to consistently earn abnormal returns by outsmarting the market.

However, some studies have shown evidence of abnormal returns in certain situations, such as the momentum effect, where assets with positive abnormal returns tend to continue their outperformance, and the value effect, where assets with low valuations tend to outperform assets with high valuations.

In conclusion, an abnormal rate of return is the difference between an asset's actual return and its expected or average rate of return. Positive abnormal returns indicate outperformance, while negative abnormal returns indicate underperformance. Abnormal returns are important for investors to evaluate investment decisions and portfolio performance and for academic research to study financial market efficiency.