Horizon Analysis
These are used to identify trends in price movement at key points based on the role of support and pressure.
What Is Horizon Analysis?
Horizon analysis is one of the essential methods to help investors identify trends. Horizontal lines are used to identify trends in price movement at key points based on the role of support and pressure.
Many of the analysis tools we use, such as support and resistance levels, trend lines, price patterns, moving averages, etc., serve to assist us in identifying trends.
The technical analysis allows us to make our investments more planned and risk-controlled. We should not think the horizontal lines have some magical "prediction" function.
The real function of the horizontal lines is to help investors to make plans for entering (or exiting) the market.
Drawing horizontal lines can provide an essential basis for investors to buy and sell so that investors only make critical decisions based on intuition to improve investor execution.
The market tends to stop going up or down on customary numbers. Investors always prefer to use significant customary numbers, such as 10, 20, 25, 50, 75, 100, and whole multiples of 100.
Thus, these habitual numbers often become "psychological" support or pressure levels. Based on this, traders can close out their positions when the market approaches an important habitual number and realize profits.
Horizon Analysis Techniques
The horizontal analysis method has two specific techniques: Comparative Financial Statements and Index-Number Series.
1. Comparative Financial Statements
The comparative analysis method analyzes the financial statements of a listed company for two years, intending to identify differences between individual items from year to year to detect certain trends.
In addition to examining trends for individual items, this analysis can break down the relationship between specific items to reveal hidden problems.
For example, when the cost of goods sold (COGS) increases by 14% while sales increase by 10%, it was determined that costs increase faster than revenues.
This is contrary to the general assumption that revenue and cost of sales increase in the same proportion when product and raw material prices are constant.
This disparity between COGS and revenue changes occurs due to three different changes:
- a decrease in the price of the product
- an increase in the price of raw materials
- a reduction in production efficiency.
Determining the exact cause requires further analysis with the help of other methods and information.
2. Index-number Series
When it is necessary to compare financial statements for over two years, the comparative analysis method becomes cumbersome, and the exponential trend analysis method is created.
When using this method to analyze financial statements of consecutive years, the data from the earliest year is typically used as the base period.
The data value of the base period is set at 100, and the data of the other years are converted into a percentage of the base period data.
The magnitudes of the relative numbers are then compared and analyzed to derive trends for the items in question.
When using indices, it is essential to note that the trends in the percentages obtained from the indices are based on the base period as a reference.
The indices are comparisons of relative numbers, which have the advantage that changes in values over multiple periods can be observed, and trends in values over time can be derived.
If inflation is considered and the index is divided by the inflation rate, the actual change in the amount after removing the inflation factor is obtained. This figure will be more informative.
This method is useful when using past trends to make predictions about future values. It allows you to observe the magnitude of changes in values and identify significant differences that can provide direction for the next step in the analysis.
Investment Horizons and Portfolio Construction
The investment horizon determines the length of time an investor aims to maintain their portfolio before selling securities for a profit. Different factors can affect the duration of one's investment.
However, the main determining factor is often the investor's risk tolerance.
Building a long-term investment strategy may feel daunting, but it allows investors to feel more confident about their investments and build a clear picture of their future.
A portfolio, which is a selection of investment varieties and their weights. For example, a stable investor’s portfolio may contain 60% in bonds (usually considered lower risk) and 40% in stocks.
In equities, there may be more emphasis on lower-risk stocks for an active investor's portfolio. As a result, it may have a significant equity weighting and mostly higher risk, higher return stocks in equities.
Investment strategies involve forecasting macroeconomic and industry trends, determining when economic growth and decline are expected, and understanding when aggressive investment strategies may be adopted.
Steps
Building an investment portfolio requires a thoughtful and precise planning process that involves the following five basic steps:
1. Determine portfolio investment policy
The investment policy includes the guidelines investors should follow to achieve their investment objectives.
It includes the determination of the three aspects of investment objectives, investment scale, and investment targets, as well as the investment strategies and measures to be taken.
Investment objective refers to the investment rate of return an investor expects to obtain while taking certain risks.
2. Conduct investment analysis
Examine and analyze the specific characteristics of individual securities or portfolios of protection in the type of financial assets identified in the first step of portfolio management.
This helps to identify which securities have prices that deviate from their value.
It also helps clarify the mechanisms of price formation of these securities, the reasons that influence their prices, and the mechanisms of their action.
3. Construct the portfolio
Three issues should be taken into account when constructing the portfolio: individual security selection, investment timing, and diversification.
4. Revise the portfolio
Correction is actually the process of revisiting the first three steps. Over time, the portfolio may no longer be the optimal combination of investments.
To cope with such changes, the investor must make adjustments to the existing portfolio to increase their payout.
5. Evaluate performance
Performance evaluation is the final stage of portfolio management and can also be seen as part of a continuous process. That is, it is seen as a feedback and control mechanism in the portfolio management process.
Estimating Returns Level
The required rate of return (required return) is the minimum expected rate that an investor would require on an investment in an asset over a certain period, given the asset's riskiness.
It represents the opportunity cost of investing in the asset, i.e., the highest expected return from other similarly risky investments. In other words, it is the threshold value that fairly compensates for the risk of the asset.
The valuation examples given will illustrate the use of explicit models based on market data and required returns. For simplicity, we will refer to any such estimate of the required return used in the example as the needed return of the asset.
For example, in the capital asset pricing model (CAPM), the required return of an asset is equal to the risk-free rate of return plus a premium or discount associated with the asset's sensitivity to market returns. This sensitivity can be estimated based on the observed market portfolio and the asset's return.
This is an example of a required return estimate for a formal model based on market variables (rather than the return requirements of individual investors).
Market variables should contain information about the risk perception and risk aversion of investors' assets, which are important in determining fair risk compensation.
Horizon analysis can help investors explore the middle ground between the future and the present. Such an analytical framework indicates the level of returns over the planned investment horizon.
Using Horizon Analysis to Relate Portfolio With Sources of Return
To determine the factors that determine the investment horizon, we must first understand the definition of the investment horizon. The investment horizon is the outcome of the project and all the work required to produce that outcome.
There are four main factors: market competition, business model, investment efficiency, and operational risk.
- Market competition
The existence of market competition will make the project organization continuously provide more product features and more services to customers, which can result in the continuous expansion of the project scope. - Business model
Understand a company's business model and analyze technology, operation, and cooperation models. - Investment efficiency
Any project should consider the investment benefits. If the input of increasing the scope of work is greater than the output, it is very undesirable. - Operational risk
This is an important factor affecting the scope of work trade-offs. It should be analyzed from the risk probability, risk consequences, and gain-loss ratio.
The value of a bond is the present value of the cash inflows that an investor expects to receive when investing in a bind.
The cash inflow of a bond consists mainly of the interest and the principal recovered at maturity or the cash received upon sale. Therefore, a bond is worth buying when it is undervalued- the purchase price is lower than its value.
1. The value of a bond
When purchasing bonds, people receive income in 3 ways:
- Coupon income
- Interest on interest
- Capital gains from the sale of bonds.
Coupon incomes include coupon payments and accrued interest received in the event of an early sale of the bond. Interest-on-interest is the return received through reinvestment, also called compound interest.
The amount of interest introduces uncertainty because the projections of specific carriers and reinvestment rates need to be based on future data.
Interest should be included in the valuation of bond investments because it can represent a significant percentage of the total return on long-term bonds.
To overcome this uncertainty approach, we can assume a constant reinvestment rate. Horizon analysis can be used to explore the effects of uncertainty associated with reinvestment by decomposing expected returns over some feasible range of values.
The capital gains component of the return is the increase in the bond’s market value.
2. Capital transfer income
Capital transfer income is the uncompensated acquisition of capital in kind or cash by an institutional unit from another institution for investment purposes. This action increases the net value of a company's financial or non-financial assets.
Capital transfer income includes income from physical capital transfers and income from cash capital transfers.
Income from physical capital transfers includes obligations other than inventory and cash involving the acquisition of ownership of capital goods, land, intangible assets, or financial assets or cancellation by creditors.
These three essential sources of return apply to any investment medium. Bonds can generate a higher portion of income over the long term than other classes of securities.
This income is derived from relatively predictable coupon and redemption flows. Short- and medium-term investment horizons reduce the likelihood of capital gains, thereby increasing the uncertainty of total bond returns.
Horizon analysis helps to compare and differentiate the returns of bonds over a specific time. Thus, horizon analysis leads to an important refinement of the capital gains component through this distinction.
Using Horizon Analysis to Estimate the Yield Accumulation Return
The cumulative rate of return is the summation return of a fund from the beginning of its inception operation to the present.
This includes the return from cash dividends and the return generated by the fund's net worth change words and can measure the return of a fund since its inception.
The key to a fund's rate of return is the fund's investment rate of return. It is the ratio of the actual return on a fund's investment in securities to the cost of the investment.
The higher the investment return value, the greater the earning power of the fund's securities. If the purchase and redemption of fund securities are subject to charges, the calculation should consider the payments.
To obtain an approximate measure of cumulative bond returns, the cross-linear analysis adds the incremental capital gains component to the bond returns.
The effect of market uncertainty due to daily changes in market interest rates does not impact the capital gains component. This return, the cumulative income return, can continue to grow over a longer investment horizon.
In the horizon analysis, we use the percentage of the current investor base to represent cumulative percentage returns. Volatility is measured similarly, with the concept of volatility over time added to the representation of capital gains.
related Terms to Horizon Analysis
The horizontal analysis method plays a considerable role in the financial field. This analysis method provides investors with an estimate of the rate of return on returns. In addition to this, there are some terms related to horizontals that are very important.
1. Horizon risk
Horizon risk is the risk that the term of your investment may be unexpectedly shortened. For example, if you lose your job or the roof of your house needs to be replaced immediately, you might have to sell some of your investments, including those you hope to hold for the long term.
2. Short-term horizon
Short-term horizon investments are those expected to last less than five years. These investments are suitable for investors anticipating the need for cash soon or nearing retirement.
3. Retirement horizon
The Horizon 401(k) Plan is a retirement savings plan that provides an element to your overall retirement portfolio. It is available to employees of an organization that uses this plan.
4. Trading horizon
The trading horizon is the length of time an investor is willing to hold a portfolio. This length of time is directly proportional to the level of risk an individual is willing to take.
The range for a single trading period is the highest and lowest prices traded during that trading period. For multiple periods, the range of trades is measured by the highest and lowest prices within a predetermined time frame.
The relative difference in price highs and lows, whether on a single candlestick or on many candlesticks, determines the historical volatility of prices. The magnitude of volatility can vary from asset to asset and security to security.
Investors prefer lower volatility, so prices become significantly more volatile, supposedly indicating some market turmoil.
The range depends on the type of security; for stocks, it depends on the industry in which they operate. For example, fixed-income instruments have a much narrower range than commodities and equities, which have much more significant price volatility.
Even fixed-income instruments like Treasury bonds or government securities typically trade in a smaller range than junk bonds or convertible securities.
Horizon Analysis FAQs
This analysis provides investors with practical recommendations by comparing a portfolio's expected discounted returns over multiple time horizons.
Investors tend to use this type of analysis to assess the expected value of a fixed-income portfolio.
The risk is that an unforeseen event could shorten the scope of the investment. This may force buyers to sell assets they expect to hold for a long time. Buyers may lose money if they must sell when the market falls.
The fund industry will maintain a long-term trend of stable growth. For the majority of small and medium-sized investors with limited capital and insufficient investment experience, it is difficult to achieve the ability to combine investments and diversify risks.
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