What are Simple Return and Log Return

In the field of finance, measuring and analyzing investment returns is a crucial aspect of evaluating the performance of an asset or a portfolio. Two commonly used methods for calculating returns are simple return and log return. While both approaches aim to capture the change in value over a given period, they differ in their mathematical calculations and interpretations. In this article, we will explore the concepts of simple return and log return, their formulas, and how they are applied in financial analysis.

Simple Return:

Simple return, also known as arithmetic return or absolute return, is a straightforward method to measure the gain or loss of an investment relative to the initial investment. It is expressed as a percentage and represents the difference between the final value (or terminal value) and the initial value of an asset, divided by the initial value. The formula for calculating simple return is as follows:

Simple Return = (Final Value - Initial Value) / Initial Value * 100

For example, if an investor purchased 100 shares of a stock at $10 per share and sold them later at $15 per share, the simple return would be:

Simple Return = ($15 - $10) / $10 * 100 = 50%

The interpretation of a positive simple return indicates a profit, while a negative simple return signifies a loss. Simple return is widely used due to its simplicity and ease of calculation. However, it does not account for the compounding effect of returns over time.

Log Return:

Log return, also known as continuously compounded return or natural logarithmic return, addresses the limitation of simple return by considering the compounding effect. It measures the relative change in the logarithm of the investment’s value over a given period. The formula for calculating log return is as follows:

Log Return = ln(Final Value / Initial Value) * 100

In this formula, “ln” represents the natural logarithm. Log return is expressed as a percentage, just like simple return.

Let’s continue with the previous example. If an investor wants to calculate the log return for the stock purchase where the initial value is $10 and the final value is $15, the calculation would be:

Log Return = ln($15 / $10) * 100 ≈ 40.55%

The interpretation of log return is similar to that of simple return. Positive log return indicates a profit, while negative log return indicates a loss. The advantage of log return lies in its mathematical properties, particularly the additivity. When calculating the returns of multiple periods, summing the log returns is equivalent to calculating the log return for the entire period, ensuring accurate aggregation of returns.

Coding:

Before running the code, we need to install necessary libraries. The yfinance library is a Python package that provides a simple and convenient way to download historical market data, such as stock prices, from Yahoo Finance. It acts as a Python interface to the Yahoo Finance API, allowing users to retrieve financial data for a wide range of securities, including stocks, ETFs, mutual funds, and more. You can use the following commands to install them:

pip install yfinance
pip install pandas

import yfinance as yf
import pandas as pd
import numpy as np

# Define the stock symbol and time period
stock_symbol = "AAPL"
start_date = "2022-01-01"
end_date = "2022-12-31"

# Download historical price data using yfinance
stock_data = yf.download(stock_symbol, start=start_date, end=end_date)

# Calculate daily simple returns
stock_data["Simple_Return"] = stock_data["Close"].pct_change() * 100

# Calculate cumulative simple return
cumulative_simple_return = (1 + stock_data["Simple_Return"] / 100).cumprod()

# Calculate log returns
stock_data["Log_Return"] = np.log(stock_data["Close"] / stock_data["Close"].shift(1)) * 100

# Calculate cumulative log return
cumulative_log_return = stock_data["Log_Return"].cumsum()

# Print the results
print("Simple Returns:")
print(stock_data["Simple_Return"])
print("\nCumulative Simple Return:")
print(cumulative_simple_return)

print("\nLog Returns:")
print(stock_data["Log_Return"])
print("\nCumulative Log Return:")
print(cumulative_log_return)

In the code, we first define the stock symbol (stock_symbol) and the desired time period (start_date and end_date). Then, we use yf.download() to fetch the historical price data for the specified stock and time period.

Next, we calculate the daily simple returns by applying the percentage change formula (pct_change()) to the “Close” price column. We also calculate the cumulative simple return by cumulatively multiplying the daily simple returns.

To calculate the log returns, we use the logarithmic formula with np.log() and calculate the percentage change. Similarly, we compute the cumulative log return by cumulatively summing the daily log returns.

Finally, we print the results, displaying both the individual simple and log returns, as well as the cumulative values.

You can modify the stock symbol and time period to suit your needs and analyze the returns for different stocks or time frames.

Comparing Simple Return and Log Return:

The key distinction between simple return and log return lies in their mathematical properties and interpretations. Simple return directly measures the absolute change in value, while log return measures the relative change on a logarithmic scale.

Simple return is intuitive and widely used in financial analysis due to its simplicity. It is suitable for shorter time frames and does not account for the compounding effect. On the other hand, log return is commonly used in academic research, portfolio management, and risk modeling. It accounts for the compounding effect and enables accurate aggregation of returns over multiple periods.

It is important to note that while both simple return and log return provide valuable insights into investment performance, the choice of which measure to use depends on the specific context and requirements of the analysis. Financial analysts and researchers need to consider factors such as the investment horizon, the presence of compounding effects, and the purpose of the analysis when selecting an appropriate return measure.

In conclusion, understanding simple return and log return is essential for evaluating investment performance and conducting financial analysis. While simple return offers simplicity and ease of calculation, log return addresses the compounding effect and enables accurate aggregation of returns. By utilizing these measures appropriately, investors and analysts can gain a comprehensive view of investment performance and make informed decisions.