In the financial world, abnormal returns are actual returns which vary from the expected returns on securities and other financial instruments. Abnormal returns can be positive or negative, and they are a common concern for investors and other people involved in financial markets. Financial analysts spend a great deal of time and energy carefully predicting the performance of overall financial markets and specific financial instruments to reduce the risk of negative abnormal returns.
In a simple example of abnormal returns, a financial market might be expected to grow by 10%, and a specific stock within that market might grow by 20%, generating an abnormal return of 10%. Conversely, the stock could grow by five percent, creating an abnormal return of five percent below the expected return. Abnormal returns can involve a wide variety of markets and financial instruments, and they can vary radically, from a few percentage points to a very dramatic and notable difference.
A number of calculations go into the process of developing expected returns. Considerations include the history of a market's performance, ongoing political issues, and general economic trends. Calculating expected returns can be highly challenging, especially with large and complex markets which can be very vulnerable to a variety of events. Abnormal returns can occur because of events which skew the market, ranging from a run on a particular stock which causes the value to rise to a natural disaster which causes a decline in stock values.
Consistently negative abnormal returns are a cause for concern because they suggest that expected returns are not being calculated correctly, and that a particular financial instrument is experiencing some volatility. Regularly positive returns can also be a cause for concern, as they may suggest that a financial instrument is overvalued and at risk of collapsing in value, or that falsification of performance records is occurring. This is especially true when returns follow a consistent upward trend with little variation in growth; a financial instrument will rarely grow by the same amount each year, for example, and abnormal returns which follow suspiciously regular patterns can be a sign of financial shenanigans.
Sometimes, an analysis of abnormal returns can explain why they occurred. Catastrophic economic events, sudden political changes, and environmental issues like droughts can all impact the performance of financial markets and individual instruments within those markets. At other times, the causes behind variations between expected and actual returns cannot be easily explained; markets can be fickle, and sometimes they behave highly erratically.
