What are Excess Returns?

Malcolm Tatum

Sometimes referred to as extra abnormal returns, excess returns are the amounts of return realized on an investment that are above and beyond the amount that was originally projected. An unusual return on the security in question may focus on shifts in the riskless rate, or have to do with shifts in some type of market measure, such as an index fund. Typically, the unusually high returns are triggered by some event that was not foreseen when the projection was formulated. These events may have to do with unforeseen movements in the marketplace itself, or be related directly to the issuer of the stock experiencing the unusually high return.

Businessman with a briefcase
Businessman with a briefcase

When evaluating a particular security for purchase, investors tend to consider all relevant factors that could have an effect on its future performance. For example, if an investor was looking at the purchase of ten thousand shares of stock, he or she would consider the current status of the shares as well as the past performance of the stock. In addition, the investor would look closely at the stability of the company that issues the shares, and any indicators that help to provide clues as to how the stock will perform in the future. If the investor determines there is a good chance to earn an acceptable rate of return, the purchase can then take place.

Excess returns come into being when that security performs at a level that is beyond anything the investor expected to happen. There are a number of reasons why this could happen. The acquisition of new leadership that boosts confidence in the well-being of the company issuing the stocks will sometimes drive the unit price upward. An unanticipated increase in the demand for the goods and services of the business is also likely to drive the value of the shares upward. Mergers that are considered favorable will also generate an unanticipated level of return for the shareholders. Even factors such as lawsuits, unexpected outcomes of political elections, and natural disasters that temporarily cripple the ability of competitors to satisfy their customers have the potential to result in excess returns.

It is important to note that when excess returns are generated, the conditions that brought about those unusually high returns may or may not continue to influence the value of the securities. For example, if the increase was due to a few competitors being temporarily unable to meet demand, there is a good chance that the value of the stock will drop slightly in value once the competition is able to function at full capacity once more. This means that investors should not necessarily see excess returns in one financial period as an indicator of how the stock will perform in future periods. Instead, the investor must look closely at the factors that triggered the unanticipated increase in returns, determine the long-term effects of those factors, and then decide whether to hold, sell, or acquire more shares.

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