Abnormal returns are what stock market investors crave -- as long as they're abnormally high. After all, abnormal returns can refer to outperformance or underperformance. Every investor wants to outperform the market, but only a few do so successfully. Through a combination of skill and luck, some investors, like Warren Buffett, can construct investment portfolios that beat average stock market returns.
To understand abnormal rates of return, you first need to understand actual returns. Say you invested $50,000 at the beginning of the year in a portfolio of 20 stocks that are components of the Standard & Poor's 500 index. At the end of the year, you see that your investment has grown to $55,000 -- a 10 percent return. Over the same period, the S&P 500 has only increased by 8 percent.
The question now becomes whether the 10 percent return on your investment portfolio matches expected performance. Based on the capital asset pricing model, or CAPM, developed in the 1960s, expected returns are calculated as follows: risk-free rate + (beta) x (market return – risk-free rate). U.S. Treasury returns are typically selected for the risk-free rate. Let's assume that the one-year Treasury rate is 2 percent. The beta reflects the extent to which a stock or portfolio moves in line with the overall market. Let's say that the beta for our portfolio of 20 stocks is 1.2, meaning that, on average, the portfolio increases by 1.2 percent every time the index rises by 1 percent. Finally, the market return represents investors' expectation about the overall stock market. Let's assume that investors believe the S&P 500, on average, increases by 10 percent each year.
In our example, the investment portfolio returned 10 percent, whereas the S&P 500 returned 8 percent. Plugging our assumptions into the CAPM formula, we find that the portfolio's expected return is 11.6 percent. Since the portfolio's actual return was 10 percent, it actually underperformed relative to expectations despite outperforming the S&P 500. Therefore, the portfolio generated a negative abnormal return of 1.6 percent.
Why Abnormal Returns Matter
Abnormal returns are a critical concept in finance because they shed light on risk-adjusted performance. Just because an investment outperforms the overall stock market doesn't mean that an investment manager did a great job. In fact, the opposite is often true. The earlier example illustrates how risk-adjusted performance offers a more accurate picture of performance. A portfolio's beta is therefore critical to determine an investment's riskiness and expected and abnormal returns.
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