Abnormal Return: Meaning, Formula, Examples & Tax Implications in India

 

Introduction: What is Abnormal Return in Finance?

In the world of investments and portfolio management, one term often used to assess the performance of a stock or portfolio is "Abnormal Return". It refers to the returns generated by a security or investment that exceed or fall short of the expected benchmark or market return.

Understanding abnormal returns is vital for investors, fund managers, analysts, auditors, and tax professionals, as it plays a key role in evaluating market efficiency, portfolio success, and tax planning. Whether you're analyzing equity performance, assessing risk-adjusted returns, or conducting forensic audits, this concept helps determine the true value created beyond market movements.

Definition of Abnormal Return

Abnormal Return refers to the difference between the actual return of an investment and its expected return, usually based on a benchmark index or predicted model.

It represents how much better or worse an investment performed compared to expectations.

Detailed Explanation

1. How Abnormal Return Works

To measure whether an investment overperformed or underperformed, analysts calculate expected returns based on historical data, market trends, or asset pricing models like the CAPM (Capital Asset Pricing Model). The abnormal return is the deviation from this expectation.

Formula:

$$\mathbf{\text{Abnormal}}\mathbf{\text{Return}}=\text{Actual Return}-\text{Expected Return}$$

Where:

• Actual Return is the return actually earned by the asset over a given period.

• Expected Return is calculated using models like CAPM:

$$\text{<br>}\text{Expected Return}=R_f+\beta (R_m-R_f)<br>$$

(Where $R_f$ = risk-free rate, $R_m$ = market return, $\beta$ = beta of the stock)

2. Types of Abnormal Returns

Type	Description
Positive Abnormal Return	Occurs when actual returns exceed expected returns. Seen as favorable.
Negative Abnormal Return	Happens when actual returns fall below expected. Considered underperformance.
Cumulative Abnormal Return (CAR)	The total of abnormal returns over a specific period, often used in event studies.

3. Why It’s Important

• Performance Measurement: Helps investors evaluate if the portfolio manager added real value.

• Market Efficiency Testing: Used in event studies to test if markets reflect all available information.

• Stock Selection Strategy: Aids in identifying consistently outperforming or underperforming stocks.

• Audit & Compliance: Detects insider trading, price manipulation, or erroneous reporting.

Accounting Illustration with Journal Entry

Suppose an investment yields ₹20,000 in returns, and the expected market return is ₹15,000.

• Abnormal Return = ₹20,000 - ₹15,000 = ₹5,000

While this is an analytical result, no journal entry is required unless it impacts valuation or accounting disclosures.

But in some financial reports:

 

Entry (if revaluation of investment required):

Investment Account Dr. ₹5,000  
   To Revaluation Reserve / Gain on Investment ₹5,000  
(Being adjustment for abnormal gain over expected return)

Tax Implications in India

In India, abnormal returns themselves are not separately taxed but are part of Capital Gains.

• If Abnormal Returns are part of Sale of Shares/Assets:

  • Short-Term Capital Gains (STCG): Taxed at 15% (if listed).

  • Long-Term Capital Gains (LTCG): Taxed at 10% beyond ₹1 lakh (for listed equity).

• If Earned Through Mutual Funds or PMS:

  • Returns are taxed based on holding period and fund type.

• Audit & Compliance Note:
  Significant abnormal returns may be subject to scrutiny under the Income Tax Act, especially if linked to price manipulation or insider trading.

Example:

Example 1: Positive Abnormal Return

• An investor buys shares of Company X.

• Actual return after 3 months = 12%

• Expected market return = 8%

• Abnormal Return = 12% - 8% = 4%

This means the investment outperformed the market by 4%.

Example 2: Negative Abnormal Return

• Actual return = 5%

• Expected return = 9%

• Abnormal Return = -4%

The investor underperformed the benchmark.

FAQs about Abnormal Return

❓ What is the difference between normal and abnormal return?

Normal return is the expected return based on risk and market factors, while abnormal return is any deviation from that expected value.

❓ How is abnormal return calculated?

It is calculated as:
Abnormal Return = Actual Return – Expected Return

❓ Is abnormal return always good?

Not always. A positive abnormal return is desirable. A negative one indicates underperformance.

❓ Do abnormal returns attract higher taxes in India?

No special tax is levied for abnormal returns. They are taxed under capital gains based on holding period and asset type.

❓ How do analysts use abnormal return?

They use it to evaluate stock performance, test market reactions to events, and detect irregularities in trading behavior.

Related Terms

• Capital Gain
• Market Efficiency
• Expected Return
• Risk-Adjusted Return

• Alpha in Investing

✅ Conclusion

Abnormal return is a key metric in investment analysis, performance evaluation, and risk management. Whether you're an investor or tax advisor, understanding this concept helps assess actual value creation beyond market trends. Keep an eye on it when planning your financial strategies or analyzing portfolio outcomes.