Understanding Abnormal Returns
When your portfolio returns more surprises than a magician pulls rabbits from a hat, you might be dealing with an abnormal return. These are the returns on stocks, bonds, or portfolios that straddle the line of expectation like an acrobat on a tightrope. But these returns aren’t just pulling a rabbit out of the hat; they could be revealing the magician’s sleight of hand or even some unforeseen event that shook the market like a snow globe.
Key Takeaways
- Vagaries of Return Expectations: Just as your daily weatherman bafflingly predicts rain under a cloudless sky, abnormal returns baffle by deviating from the expected path.
- Double-Edged Sword: These returns can cut both ways—splendidly positive or disastrously negative.
- Source Exploration: Delving into these abnormalities in returns could either uncover a hidden gem of an investment strategy or expose a landmine.
- Measure for Measure: A cumulative abnormal return (CAR) sums up these deviations, offering a clearer picture of an investment’s performance during turbulent times.
Cumulative Abnormal Return (CAR)
Imagine if you could weigh all the Easter eggs you’ve found years after the hunt. That’s somewhat analogous to the Cumulative Abnormal Return (CAR)—it aggregates these surprises over a period. Interested in knowing how a series of company blunders or blockbuster announcements played out in the stock price? CAR is your go-to metric.
Employed often in event studies, CAR helps disentangle the noise from the signal—distinguishing between usual market static and genuine reactions to real news.
Examples Shine a Light
Consider a juggler—the more balls in the air, the bigger the spectacle. Similarly, the higher the abnormal return, the more glaring the performance—or underperformance. For instance, an investor celebrating a 15% return against a drab 5% expected market return is a scene worth the applause, showcasing how discerning the investor is, or possibly how much luck had a role to play!
Conversely, if the market was the stage for a 12% return while our investor’s assets limped home with 5%, then it’s less of a curtain call and more of a trapdoor fall.
Related Terms
- Alpha: While abnormal return is the odd duck, alpha is its domesticated cousin, marking the excess returns of an investment relative to the return of a benchmark index.
- Beta: The measure of a stock’s volatility in relation to the overall market. If abnormal return is the performance, beta is the difficulty level.
- CAPM (Capital Asset Pricing Model): The Sherlock Holmes of finance, CAPM investigates the expected returns of an asset based on its risk relative to the market.
Recommended Readings
- “The Misbehavior of Markets” by Benoit Mandelbrot explores the chaos and complexities of market behavior which could lead to abnormal returns.
- “A Random Walk Down Wall Street” by Burton Malkiel, a book that could easily take a stroll through the quirky nature of stock market predictions and their outcomes—including those abnormal returns.
Abnormal returns are the market’s way of keeping things interesting, ensuring our investment journeys are filled with as many twists and shocks as a bestselling thriller. Whether it’s a sign of skill, luck, or something fishy, it’s always worth a closer examination.
