Global portfolios should be optimized in excess, not total returns

Erik Norland and D.Sykes Wilford

Review of Financial Economics, 2002, vol. 11, issue 3, 213-224

Abstract: When constructing portfolios, practitioners must take opportunity cost into account and view returns as excess, not total returns. Using total returns in a means–variance optimization—a remarkably common error—introduces a bias that will cause “optimal” portfolios to overweight domestic cash securities at the expense of higher‐risk instruments and instruments invested abroad. The original work on modern portfolio theory made little mention of excess versus total returns in optimization in part because the theory assumed one was only choosing between risky assets and that all of the assets were denominated in the same currency. Thus, those who refer to the original version of the theory could easily misapply it when considering assets in different currency zones. This paper seeks to demonstrate the problems and biases inherent in using total returns versus excess returns in means–variance optimization.

Date: 2002
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https://doi.org/10.1016/S1058-3300(02)00047-2

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Persistent link: https://EconPapers.repec.org/RePEc:wly:revfec:v:11:y:2002:i:3:p:213-224

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