Definition: Abnormal rate of return or ‘alpha’ is the return generated by a given stock or portfolio over a period of time which is higher than the return generated by its benchmark or the expected rate of return. It is a measure of performance on a risk-adjusted basis.
The abnormal return on an investment is calculated as follows (1): RAbnormal = RActual – RNormal An investment’s abnormal return could be positive or negative. It essentially measures how the stock or a fund has performed over a given period of time. Abnormal rate of return as a measure of performance is useful to investors as a valuation tool and for comparing returns to market performance (2).
Suppose a stock ABCD experiences a 30% return in a given year. Analysts expected ABCD to experience a return of 20% for that year. The (positive) abnormal rate of return ABCD is:
30% actual return – 30% projected return = 10% positive abnormal return
ABCD experience a positive abnormal return of 10% during that year.