Confounding the Return Notions Could Be Dangerous

Günter Bamberg and Sebastian Heiden

Chapter 2 in Modern Finance and Risk Management:Festschrift in Honour of Hermann Locarek-Junge, 2022, pp 9-25 from World Scientific Publishing Co. Pte. Ltd.

Abstract: In numerous finance publications, the term ‘return’ appears at first only as a necessary element for further research. Seemingly, it is so basic that it does not require a precise definition. However, the inappropriate use of ‘return’ has serious consequences. This chapter shows that confounding the return notions and inappropriate approximations lead to wrong results in portfolio optimisation. Using log-returns instead of ordinary (or simple) returns in a traditional Markowitz framework can feign arbitrage opportunities which are nonexistent in reality. Furthermore, this chapter highlights the huge numerical differences between key figures of log-return and ordinary returns. For instance, calculating the Sharpe ratio with log-returns can signalize a bad investment, whereas it is a really highly profitable investment.

Keywords: Finance; Risk Management; Commodities; Energy Finance; Risk; Cryptocurrencies; Asset Management; Banking; Behavioral Finance; Behavioural Finance; Markowitz; Portfolio Selection; Asset Allocation; Crowdfunding; COVID; Pandemic; Corona; Investment Strategies; Low-Risk Investments; Social Banks; Excess Liquidity; Cost of Capital; Utilities; Network Industries; Private Equity; Small and Medium-Sized Enterprises; Black Swan; Statistical Inference; Maximum Likelihood; Bayesian Methods; Tail Risks; Conditional Value-at-Risk; Tail Nonlinearly Transformed Risk; Capital Constraints; Bank Regulation; Subjective Risk Assessment; Expert Knowledge; Model Risk; Risk Factors; Option Pricing; Volatility; Resilience; Supply Chains; Disruption; Systemic Risk; Oil; Renewable Energies; Corporate Risk Management; Power Purchase Agreements; Gold; Precious Metals; Dynamic Correlation; Mixed Data Sampling (search for similar items in EconPapers)
JEL-codes: G11 G3 G32 G4 (search for similar items in EconPapers)
Date: 2022
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