A single stock or portfolio of stocks which varies in the market average is defined as abnormal return in the stock market trades. If the stock outperformed the market average then the abnormal return will be positive, and if it underperformed then it will be negative. This abnormal return definition is relevant with financial gains and losses which are measured against the actual index instead of artificial or hypothetical measure. Broad based performance of an index is usually called the market average such as the Standard & Poor’s 500 is widely followed index in United States. Other countries are having their own market index according to their national markets for purposes of determining abnormal returns.
Calculation of Abnormal Return:
Initial abnormal return calculations are little simple which are done by subtracting the index performance from the individual stock or portfolio’s performance. That’s the raw measuring of stock’s performance in a certain time period, this measuring wont calculate the fluctuations which are naturally over a given period. The percentage sum of all abnormal returns over a defined period of time is called cumulative abnormal calculation that account for these normal variations.
Simple abnormal return formula can be described as:
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(performance of individual stock/portfolio) – (index performance) = (abnormal return)
Similarly, cumulative formula will become:
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(sum of daily abnormal returns of individual stock/portfolio) – (sum of all daily index performances) = (cumulative abnormal return)
Using this formula practically, there are many other factors which are used to derive the cumulative abnormal return result. To eliminate statistically meaningless results these weighing factors are used and gains or losses clearly derive of outside market factors.
What’s the importance of abnormal returns?
Event or market change which directly affects the stock portfolio is related to abnormal returns. Initial public offerings, mergers, any major news or market events are the factors for abnormal returns. Such as news of a major legal action against a company will drive that company’s stock downward significantly, which will cause losses to far exceed the general market performance as measured by one of the leading indexes. This major loss is called abnormal return and that’s negative one. It will be measured like this if that company’s stock losses 10% overall of its value and the market index increased 5% then we can conclude the range of abnormal returns by using the abnormal return formula. The company losses were 10% and the market index was increased 5% so minus 10% minus 5% (-10% – 5%) = – 15%. which is more significant loss as it appeared first. Exact and true extent of losses and potential losses only market analysts and investors can determine.
Cumulative abnormal return calculations provides longer term information to analysts such as major event on a stock’s price and it also reflects the overall stock’s stability which allow a more precise estimation of the stock’s true value.
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