Nowadays, more than half of Americans are investing, and in many economically-developed European countries, over a third of those nations’ adult populations hold some security category asset. So, trading stocks is nothing unusual for common folk today. It is not a practice reserved for only the super-wealthy or the financially savvy. It is an activity that everyone with some money on the side should get into, as it helps towards building a stable retirement fund.
However, one thing that many newbies to the sphere neglect to recognize at first is the role measuring investment performance plays in the process of successful trading. It entails assessing the effectiveness of decisions made and making new ones based on available data while hoping to reach pre-determined financial goals. The operation includes identifying weaknesses and strengths, comparing trading options, managing risk, and monitoring progress. The latter step involves implementing various metrics that outline the health and potential of assets, leading to conclusions if they should get held or sold.
Time horizons play an essential part in quantifying investment performance, as this term refers to the period of time that an individual decides to hold onto a fungible asset/security before offloading it on the market. That can depend on the multiple objectives that an investor wants to hit, and determining a time horizon is a vital consideration for all, as it influences the level of risk people are willing to incur and the category of trades they are willing to partake in their investment career, or short/medium-term trading venture. We explain time horizons and their importance in-depth below.
Understanding Time Horizons
We defined above what a time horizon is – the length someone expects to have an asset in their possession for a specific aim. As a rule of thumb, most casual investors break down their trades into two primary categories, risky and not-so-risky ones. In the first group, stocks are the most famous example, and from the second cited batch, bonds are the representative that is most renowned. Bonds are a safer investment than stocks because they supply reliable returns via coupon payments, while stocks have no guaranteed profits for investors. Though, in general, stocks deliver higher returns because they carry greater risk, and shares in a company can significantly rise at seemingly a whim due to various events.
So, the shorter the time horizon, the more conservative an investor must be, allowing himself to take minimum risks because they have less time to recover from substantial losses. If one does not adhere to this guidance, they exhibit potentially perilous conduct, exposing themselves to various degrees of financial risks, depending on the investments made. Whereas, the longer the time horizon is, the more their level of aggression can grow and the riskier their behavior can be, as they have a longer playing field.
Time horizons in investing usually get divided into short-term, intermediate-term, and long-term ones. The time range in the first category usually spans between a few weeks to a few months, and investors that implement them focus more on creating quick returns that generally expose them to higher risk levels. Examples of this include option, swing, and day trading. These are activities that novice traders should avoid. In the second category, the time gamut can reach a few years. And these horizons customarily encompass investing in mutual funds, exchange-traded ones, and bonds, all carrying moderate degrees of trading hazard. Long-term horizons last up to several decades, and investments suitable for them are value stocks, long-haul bonds, and real estate. They are optimal for those not in a hurry, who are looking to achieve extensive growth down the line, who are patient regarding getting their yields, and who play a long game.
How Time Horizons Impact Investment Decisions
Going by the things said above, in a way, we defined how time horizons influence investment decisions. They touch on an individual’s risk tolerance, asset allocation, and investment objectives.
Nevertheless, they also hit on liquidity needs, which we did not mention, and that is the ability to get cash when needed. Those who favor short-term horizons require more liquidity to match their near-term requirements. But investors who favor longer horizons will probably have fewer concerns regarding their liquidity state, as they plan to hold onto their attained assets for a significant period and have fewer intentions than their short-term counterparts of making any market moves. Also, a scheme called investment horizon matching is something that some veteran traders sometimes utilize, and it features aligning the horizon with the duration of an investment. So, long-term horizon investors select long-term bonds.
Generally, the commonly held belief is that the longer one’s investment horizon is, the more options that person has to aggressively pick their investments.
Things to Know About Measuring Investment Performance Utilizing Time Horizons
Multiple metrics can get used to gauge the status of tradable security over various horizons. Yet, the ones that seem to play the highest factor are ROI (return on investment), CAGR (compound annual growth rate), and TWR (time-weighted return). ROI tells investors how much they have lost or gained on a trade. CAGR informs them of the annual rate of return, and TWR does not get affected by the timing of cash flows. It multiplies the returns for each holding period to display how they have compounded over time.
It is unwise to try and stack up investments with varying time horizons, trying to compare them on account of the difference in their risk levels, expected returns, and overall objectives. It is paramount to consider these differences when contrasting investments made by yourself or someone else. Plus, factor in the effect of fees and taxes, analyze for risk-adjusted returns and use benchmarks when weighing up asset success or failure.
Risk and Investment Horizons
Going by everything so far, it is clear that horizons and risk get closely related in the investing process. The more time one has on their side, the more chances to recover from market volatility they get en route to creating positive returns. Therefore, as previously talked about. Those with time in their pocket do not have such a massive problem taking on somewhat dangerous degrees of risk to reach their money-making goals. On their journey, they generally face five well-established types of risk that most traders fear.
The first is the dreaded inflationary hazard. It is a danger that bonds are very susceptible to, given that their coupon rate gets standardly fixed. That means that a surprising inflation spike will undoubtedly erode expended gains. So, investors must take this into consideration if they are looking into medium/intermediate-term horizons and bond investing. Needless to say, interest rate risk also typically primarily affects fixed-income securities. Although it and inflation danger also can cause sizable damage to all categories of securities quite dramatically.
Business risk is the jeopardy that an entity an investor has to pour his money into may plummet in value, slowly or swiftly, with the prices of its stocks and bonds failing drastically, potentially causing the company to go bankrupt. It is crucial to grasp that no company is immune to the potential of eventually disappearing from the face of the Earth. Pan Am, Kodak, Compaq, General Motors, and Borders are a few examples of businesses that operated successfully for decades and were global brands that have gone into the annals of history.
Investing in bonds with high credit ratings reduces one’s exposure to default risk, which is a borrower’s inability to repay debts. That is something that gets connected to debt-based securities. Hence, keep that in mind, and also factor in that everyone should always keep a close eye on the market continuously. They must do this to constantly evaluate its (the volatility) risk, the one in play with every investment. That is chiefly a concern for those exploring short-term horizons, seeking to snag quick positive returns, as most markets tend to have a rising trajectory as time passes. Rarely does an entire sector flat-line in a span of a few years. Though, that is something that many are trying to figure out if it is in the cards with industries such as movie theater distribution, whose failure would definitely lead to the downfall of the Hollywood studio system and a few other business eco-systems.
Final Thought
Traders with some years of experience under their belts know that the length of an investment horizon directly links to the category of investment products most appropriate for an investor attaining his coveted financial milestones. For most, age is an obvious tool in determining their horizons. It does not help individuals disqualify or qualify potential investments, but it aids them in appraising the suitable ones. Craved lifestyle and how one selects to spend money are other non-negligible requisites to bear in mind at this stage.
In truth, there is an exhaustive range of time horizons investors can choose, and they are the ones that pick them. That means they should factor in their goals when viewing investment performance chart visualizations, given that they choose the time the investment gets held. And that period gets selected while factoring in risk tolerance, liquidity needed, implemented tactic (asset allocation), and desired outcome.