Why do abnormal returns matter?
Abnormal returns sometimes don't matter if they're a one-time anomaly or the result of an expected fluctuation in the wider economy. But at other times, they can point to serious problems with the management of a portfolio or business. If your investment experiences chronic abnormal returns, it might indicate something like fraud or other types of manipulation are at play.
It's important to examine the abnormal returns of an investment before jumping in so that you know whether or not your investment is reliable. Another similar metric, cumulative abnormal returns (CAR), is useful to help track the effect of events like lawsuits and buyouts on the price of the stock over longer periods.
Abnormal returns versus excess returns
Excess returns sounds like it might be a subtype of abnormal returns, but they're very different in the investing world.
Abnormal returns are generally directly caused by an action of either a company or an investment manager (if the abnormal returns are for a portfolio). For example, a company might have negative abnormal returns if they were sued for a defective product that hurt a lot of people, or a portfolio manager might generate positive abnormal returns by doing a really good job at picking a basket of securities.
Excess returns, on the other hand, are essentially caused by the wider investment market. Abnormal returns may influence excess returns, but excess returns are calculated when the return of one investment is compared to another similar investment or, alternatively, a risk-free rate.
For a very simplistic example, let's assume that XYZ, Inc. returns 5% in a year, and a very similar stock, ABC, Inc., returns 7.5%. If you invested in ABC, Inc., you'd have a 2.5% excess return over XYZ, Inc., a very similar stock. In the same vein, if you invested in XYZ, Inc., and instead used a bond rate's 4.5% return for a risk-free rate comparison, you'd have an excess return of 0.5% with your investment.
Related investing topics
