[R-SIG-Finance] returns convention

[paul sorenson]

I appreciate all the responses.  It kind of confirms what I was thinking 
but I didn't want to die wondering.

  o Log returns have some neat properties for calculations.
  o The difference between log returns and simple returns for small 
changes isn't that big.
  o It sounds like log and simple returns unintentionally get used 
interchangeably from time to time.
  o I need to be careful when calculating portfolios.
  o Using functions out of some of these great packages has some traps 
for young players.

One simple case where it would be nice to know is where I am comparing 
my calculations with someone elses.  Eg comparing annualized returns or 
Sharpe ratios with numbers published on the web.

Peter Carl wrote:
> On Monday 08 October 2007 6:23:21 am paul sorenson wrote:
>> Is it usually assumed that references to "returns" are calculated as
>> diff(log(prices))?  Compared with say the simple fractional change from
>> one price to the next?
>>
>> For example, in PerformanceAnalytics I notice that the default value of
>> CalculateReturns is diff(log(prices)).
>>
>> I guess it probably doesn't matter much either way for small changes, I
>> just wanted to know if there was some common convention when I see an R
>> function that expects a returns vector.
>>
>> cheers
>>
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> 
> Despite the default you point out, most of the functions in  
> PerformanceAnalytics assume simple returns.  Perhaps an underlying question  
> is "which is the 'correct' way to calculate returns?"  but the answer for  
> what to is "neither", which is somewhat unsatisfying (to point to Jeff's 
> earlier comment).  The "better" method depends what you are trying to 
> accomplish.  Most of PerformanceAnalytics' functions are about performance 
> description, so we have erred to the simple which is slightly more 
> conservative.
> 
> Before we get to 1.0, I hope to have methods included for handling both  
> explicitly where needed.
> 
> As Eric already pointed out, continuously compounded returns have an advantage 
> over simple returns in that they are additive through time and they include 
> the effects of compounding.   The drawback to log returns is that they are 
> not additive in a portfolio.  
> 
> The simple return on a portfolio of assets is a weighted average of the 
> simple returns on the individual assets.  Average simple returns can be 
> thought of as a reasonable one-step-ahead forecast; average compound returns 
> are a better representation of the expected return over a longer period.  
> 
> But what really matters is that you are consistent, so that the comparisons 
> you make are imprecise in the same direction and the resulting relative 
> ranking is correct.
> 
> I can't speak for the assumptions of other packages or functions expecting 
> returns, but I would note that there seem to be relatively few.  If I recall 
> correctly, many functions assume prices and make the conversion.
> 
> pcc
>