Everyone works hard for their money, and their accumulated funds should return the favor by working hard for them. They do that through investments, which is how individuals take charge of their monetary security and build wealth. While most non-financially savvy people choose to save their money as a fail-safe for retirement, those who know better invest them, as they are aware that stats show that in the long-term, stock-market-based investments provide more than decent opportunities for quality returns. Moreover, risks with these can get mitigated through diversification, in other words, spreading them across different entities in varied sectors.
That said, the path of any investor toward reaching their financial goals includes coordination and measuring investment performance, as explained by StockMarketEye.com, of their securities periodically. Naturally, that, in particular, holds for active investors, who must grasp the what, why, and how of past trades to determine course modifications in current ones. In many experts’ eyes, there are four steps in the performance-measuring process. These include calculating a portfolio’s excess returns, benchmark selection, risk analysis, and performance attribution. And the truth is that it is hard to cut through the noise, as dozens of performance metrics exist nowadays. Hence, the average investor can get confused about the validity and practical need for each discovered one.
It is vital to understand that there is no clear-cut approach to calculating whether good investment decisions have gotten made and if adjustments are necessary. But it is mandatory that everyone investing can spot misleading information and benchmarks, properly factor in the level of risk involved, and not neglect the potential profits lost due to taxes and fees. These pitfalls get explained in more detail below, along with examples illustrating their significance to the investment process.
Inaccurate Data
Source: money.usnews.com
Inaccurate data, also known as dirty data, can wreak havoc on anyone’s investing decisions because information about how securities and markets are performing or about potential market shifts plays a pivotal role in managing a portfolio adequately. Also, accurate metrics can only rely on precise sources of info.
In investing, data gets gathered via various measuring devices, historical records, communication technologies, and an evolution towards smart grids (enables a two-way flow of info). Nevertheless, the more data acquired, the greater the scope for inconsistencies and inaccuracies to appear is active. Usually, their resolution happens through manual interventions, which is often mandatory before this data can get utilized to produce valuable insights. The lack of commonly-agreed data standards is a problem in the trading sphere and a challenge that most asset managers face. When relying on false information, investors can enter at a point that is too early or pull out from a trade too late. They can also make bad general choices. Even if an info source is squeaky clean, the way one calculates a given metric can differ from how others would do this because, in some aspects, investing is like gambling. It involves a sizable degree of uncertainty.
As a rule of thumb, most investors often look to P&Ls and retention calculations as a method for past showings, general ledgers, and monthly revenues as raw data, evaluate hiring plans, a bottom-up P&L model, and win probabilities for current deals for projections.
The most widely-accepted performance measuring tools use a portfolio’s return, the risk-free rate, standard deviations, alpha, and beta. These are the Treynor measure, the Sharpe ratio, and the Jensen measure. They combine risk and return performance into a value they all reach slightly differently. That can often be a mandatory requisite for optimal investment decisions, and it is for millions. Some stock trading apps have software resources that do this math automatically for users. They draw data from reputable online springs, with some sets getting entered by hand. The internal rate of return is another highly established metric that attempts to estimate an investment’s profitability by considering the net present value, the holding period, each period, the cash flow, and the internal rate of return.
As any financial educator worth their salt out there preaches, the prime sources for investment data mining are corporate filings, EDGAR – the Electronic Data Gathering, Analysis and Retrieval System, shareholder/research reports, and financial websites that present the data collected from the places mentioned in an organized manner.
More advanced investors can get into assessing the intrinsic value of the information on hand by taking into account its validity, the percent of records with correct values, its scarcity, the number of records in a dataset as a percentage of the potential records as a whole, and the period that each one can get considered as relevant. Multiple formulas supply an Okay evaluation of the performance value of information, its business quality, financial/economic relevance, and the expected value of perfect information. One can also combine these valuation models for greater input to close and identify info value gaps. Yet, that is a bit of overkill for standard investing.
Overlooking Fees and Taxes
Source: lehnerinvestments.com
As with virtually anything in business, unavoidable fees also get associated with investment products and services. The same applies to taxes, which is something that newbie investors, in particular, frequently forget to account for when analyzing trades and performances. Fees may appear small, but they can add up over time. Plus, they can reduce portfolio value drastically. For example, an annual fee of 1% in a case when someone has invested $100,000 over two decades in their portfolio and raked in a 4% return annually shall result in a $30,000 cost. Thus, it is vital for everyone to get informed that they are getting charged by the government and service providers and how they can lower or eliminate some of these commissions.
In general, fees get classified into two categories. These are transactional and ongoing ones. The first gets charged when a trade gets made, factored in at that time. The latter group is the more dangerous one for long-term investors, which can substantially reduce the value of a portfolio since they add up over time. Examples of ongoing fees are advisory commissions paid to portfolio managers, then yearly operating expenses charged by ETFs and mutual funds. There are also 401(K) fees and annual ones for those who invested in a variable annuity that must get charged to cover administrative expenses. These may include insurance fees and other optional features usually referred to as riders.
Taxes eat into investing profits by way of income and capital gains ones. For the most part, capital ones are lower than income rates, but still, for high-earners, they can be as high as 37%.
The top ways to minimize the costs of investing are through automated investing platforms and discount brokerages.
Misleading Benchmarks
Source: experian.com
Benchmarks play a vital role in investing, as they are the standard utilized to analyze risk, allocation, and return on sets of portfolios. In most cases, market indices, like the S&P 500 or Nasdaq composite, assume this part, acting as a starting point for managers to direct how securities should get allocated going forward from a risk and return perspective.
Without question, these measurements are the universal language of the financial markets. Though, if an investor opts to guide his choices using the wrong benchmark, that will inevitably lead to damage, meaning poor investing outcomes. That is so because these tools are not the impartial/unbiased judges most analysts make them out to be. But it is paramount that everyone must understand that benchmarking is one approach to measure progress toward an aim, even though it is an artificial one. And, despite popular belief, beating the market is not always the end objective for all.
The main problem with benchmarks is that they always look backward, telling traders how certain types of securities have performed in the past. Therefore, when someone is looking in the rearview, there is always the risk of steering oneself in the wrong direction, going off course. Plus, benchmarks/indices follow sections of the market via the weighted average performance of a group of securities. For instance, the Dow Jones average features America’s thirty most massive companies, but if someone is not a large-cap investor, then this index is of no interest to them. That means that following it would be wrong. So, those investing in small-cap mutual funds should not care about large-cap indexes as benchmarks.
It is always best for investors to find a benchmark that reflects their portfolio’s investments. Sometimes, it is better to create custom ones, representing how one is planning to allocate their portfolio, instead of using one of the famous indexes. Moreover, it is vital that no one let benchmarking overcomplicate the investing process. And everyone seeks to compare each of the components in their portfolio to the index’s returns now and again.
Time Horizon
What are time horizons in investing? It is the timeframe for which security gets held before it gets offloaded/sold or the investor needs the money back. They vary per the goal and can be short, medium, or long. Some also define this concept as the future distance the decision-makers look to when assessing the consequences of a proposed trading action. If the horizon is too short, investors may undervalue the returns. If it is too long, investors may spend more resources than needed while making a decision. An example of a long-term time horizon is investing for retirement. For active investors, an optional choice should get made swiftly and at a low cost while also considering the consequences that may come with the walking path, looking to incur as few as possible. Another way of looking at it is that optimal decisions ask the horizon of the investor is in line with the time characteristics of the other vital factors to the choice. Long ones can facilitate riskier and more aggressive portfolios, while shorter horizons are generally conservative.
Given all this, it is logical that no one measures a portfolio’s future without taking into account its overall time horizon.
Overlooking Risk
Source: inc.com
By definition, investment risk is the degree of uncertainty in an investment’s return differing from expectations. Essentially, this is the potential financial loss inherent in the trading process. All investments carry some degree of risk. Consequently, in finance, the fundamental concept of this realm is the relationship between return and risk.
Many individuals new to investing enter this domain overzealously, overlooking the risk accompanying this practice. Of course, that is not wise. All investors must know how much uncertainty they can endure, which gets called tolerance. Given that a financial emergency can spring up at any time, everyone should keep sufficient liquidity in their portfolio. Implementing an asset allocation strategy, like mixing asset classes, is also recommended. The same goes for investing in blue-chip stocks, doing one’s due diligence, and trying to time the market. These are the best tactics for reducing investment risk.
Several types of risk can significantly influence the performance of a portfolio. These are market/systematic, default, business, inflation, interest rate, liquidity, mortgage, opportunity, political, and specific risk. Needless to say, they affect different types of investments differently.
Conclusion
The things to appraise before laying down money in stocks, mutual funds, commodities, or whatever, and when gauging their current state and potential are looming risk, knowing time horizons, factoring unavoidably accruing fees/taxes, how to use appropriate benchmarks and accurate data. Nonetheless, even with all these things in place, there is no guarantee that investments will pan out in the long haul. Still, it is most ill-advised to build a portfolio without regularly monitoring the performance of the investments inside it and not being cognizant of the things described above.
