Investors have several options when it comes to planning for their retirement. They can make decisions based on several factors. Among other things, investors must consider the tax aspects of their retirement plans. It is a part of both their tax planning and retirement planning process. One of the accounts which investors can invest in includes tax-deferred accounts. What is a Tax-Deferred Account?A tax-deferred account is an investment account that allows investors to defer their taxes until withdrawal. With this account, investors can postpone the taxes they pay on any money they invest into it. Therefore, they don't have to account for the tax implications of these accounts until they withdraw the money. Usually, this occurs after retiring. Thus, investors can effectively postpone their taxes until after retirement. Investors that invest in tax-deferred accounts don't have to account for the returns they generate on these accounts. It also means that they don't have to report the income on their tax returns. However, as soon as they withdraw the amount from their tax-deferred account, it becomes taxable. Tax-deferred accounts are sensible investment decisions if investors are in a high tax bracket at the time of investment. How does a Tax-Deferred Account work?Tax-deferred accounts work similarly to other investments. Individuals can choose their preferred accounts, which generate returns after a specific time. Unlike other investments, however, these returns are not taxable when the individual earns them. Therefore, they don't have to account for the tax implications when they get the returns. Instead, these returns become taxable when the individual withdraws the amount. There are some rules which may restrict investors from withdrawing based on the type of account they have. Some accounts may also come with early withdrawal penalties. However, once investors do withdraw the amount, they must pay the due taxes. Therefore, investors can postpone their taxes on these returns for as long as possible. These accounts allow investors to benefit and can be crucial for tax planning purposes. On top of that, investors can invest in various tax-deferred accounts to help them maximize their benefits from postponing their taxes. For some tax-deferred accounts, the savings that investors make can be substantial. What are the types of Tax-Deferred Accounts?Investors have many options when it comes to investing in tax-deferred accounts. The most common options preferred by investors are 401(k)s and individual retirement accounts (IRA). Both have further types, such as traditional or Roth 401(k)s and IRAs. In countries such as Canada, these may include registered retirement savings plans (RRSP). Apart from these, investors also have other options. These include whole life insurance, I Bonds or EE Bonds, fixed deferred annuities, variable annuities, etc. When choosing between these, investors need to consider their needs. Most importantly, however, they must ponder the benefits they can get from each of these. ConclusionTax-deferred accounts are a great investment for investors looking for retirement plans with tax planning benefits. These accounts allow investors to postpone their returns. Therefore, they don't have to pay taxes on any returns they generate on these accounts. However, once they withdraw the amount from the account, they must pay taxes. Originally Published Here: What is a Tax-Deferred Account?
0 Comments
The trading literature mostly deals with the design and development of trading strategies. There is very little discussion on the topic of how to properly validate them, and most of the system validation techniques have been developed under a traditional statistical framework. Article [1], however, argued that using a traditional single testing framework is not enough, and provided some guidance on how to properly evaluate trading strategies using a multiple testing framework. It concluded, In summary, the message of our research is simple. Researchers in finance, whether practitioners or academics, need to realize that they will find seemingly successful trading strategies by chance. We can no longer use the traditional tools of statistical analysis that assume that no one has looked at the data before and there is only a single strategy tried. A multiple testing framework offers help in reducing the number of false strategies adapted by firms. Two sigma is no longer an appropriate benchmark for evaluating trading strategies. We agree that evaluating a trading strategy under a single testing framework is not enough, as the strategy might happen to be a winner by chance. However, we believe that the approach proposed by the authors is not practical, i.e. it’s not scalable, intuitive, and cannot be easily implemented. The article then pointed out that the Sharpe ratio is not an appropriate measure of risk-adjusted return. This is true, especially with options trading strategies whose PnLs are not normally distributed and are often heavily skewed. Our work has two important limitations. First, for a number of applications the Sharpe Ratio is not appropriate because the distribution of the strategy returns is not Normal. For example, two trading strategies might have identical Sharpe Ratios but one of them might be preferred because it has less severe downside risk.… The article also discussed the importance of adding a low-correlated trading strategy as a diversifier to a portfolio. …our work focuses on individual strategies. In actual practice, the investment manager needs to examine how the proposed strategy interacts with the current collection of strategies. For example, a strategy with a lower Sharpe might be preferred because the strategy is relatively uncorrelated with current strategies. The denominator in the Sharpe Ratio is simply the strategy volatility and does not measure the contribution of the strategy to the portfolio volatility. The strategy portfolio problem, i.e. adding a new strategy to a portfolio of existing strategies is the topic of Harvey and Liu (2014c). For more discussion on the benefit of adding a diversifier to a portfolio, read Impact of a Low Correlation Trading Strategy References [1] Harvey, Campbell R. and Liu, Yan, Evaluating Trading Strategies, https://ssrn.com/abstract=2474755, 2014 Article Source Here: What Are the Correct Methods for Evaluating a Trading Strategy? When investors make investment choices, they consider various factors. However, the most crucial among those is the risks and rewards they can get from those choices. Usually, investors expect the highest returns possible from their investments. However, each investment has a risk associated with it that can be detrimental to investors. Therefore, they may need to adjust their rewards for the risks they are willing to take. What are Risk-Adjusted Measures of Performance?Risk-adjusted measures of performance are metrics that can help investors adjust for the risks they take for their investments. These allow investors to consider both the risks and rewards they can get on their investments instead of focusing on returns only. Usually, the higher the risk is, the higher the returns are as well. By using risk-adjusted measures of performance, investors can compare various investments with varying risk levels. There are several risk-adjusted measures of performance that investors can use. Among those, the most crucial is the risk-adjusted return. On top of that, investors can also use various ratios to compare investments that come with varying risk levels. What is the Risk-Adjusted Return?The risk-adjusted return represents the return that investors can get from an investment after accounting for the risks associated with it. As mentioned above, this metric allows investors to calculate the relative profits they can gain from their investments. By considering the risks associated with the investment, investors can get better insights into the rewards they can achieve. The risk-adjusted return allows investors to compare various investments with varying risks. It works on a simple premise, allowing investors to choose investments with the highest returns for a given risk level. For example, if two investments offered the same returns, the risk-adjusted return will be higher for the ones with the lower risks. What are some Risk-Adjusted Measures of Performance ratios?Investors can get the risk-adjusted performance for an investment as ratios. It makes the comparison process more manageable, allowing investors to make better decisions. There are several ratios that can help investors gauge an investment's risk-adjusted performance measure. However, the most commonly used ones include the Sharpe and Treynor ratios. Sharpe RatioThe Sharpe Ratio allows investors to measure the returns they get from an investment that exceeds the risk-free rate per unit of standard deviation. Investors can calculate it by calculating an investment's market risk premium. After that, they must divide it by the investment's standard deviation to get the Sharpe ratio. Usually, investors prefer a high Sharpe ratio, which signifies the highest returns for the given standard deviation. Treynor RatioAnother ratio commonly used for risk-adjusted performance measures is the Treynor ratio. It uses the same principle as the Sharpe ratio. Instead of considering an investment's standard deviation, however, the Treynor ratio uses its beta. However, the ratio's principle remains the same. The higher the Treynor ratio is, the higher the risk-adjusted return for the investment will be. ConclusionRisk-adjusted measures of performance allow investors to calculate the returns they get from their investments after accounting for the risks. Therefore, these allow investors to compare investments based on how much risk they are willing to accept. There are several metrics that can help investors in calculating the risk-adjusted performance for investments. Originally Published Here: Risk-Adjusted Measures of Performance When investors choose a portfolio of stocks or securities to invest in, they have several options. They can choose between both local and international markets to select their investments. It gives them great flexibility when it comes to building a diversified portfolio. Sometimes, however, investors may allow bias to influence their decisions when selecting the market where they place their investments. What is Home Bias?The term home bias represents investors' tendency to prefer domestic investments. In this process, they ignore the certainty they can get from diversifying into foreign markets. There are some specific types of investors that demonstrate this bias compared to others. Usually, these investors have faced limitations when it comes to investing in foreign markets. Therefore, they base their decision to invest locally on those experiences. In the present, investing in foreign markets is seamless. There are no significant limitations that investors may face. However, some investors still allow their bias towards local markets to influence their decisions. Investors are also more likely to choose local investments as they may worry about the prospect of entering unknown markets. Either way, they lose the opportunity to increase their returns and build a diversified portfolio of investments. Home bias in equity portfolios can also exist when investors prefer local equities compared to foreign ones. This bias exists for investors that are active in the stock market. Even when investors invest in foreign markets, their portfolios comprise a substantial portion of local equities. It also constitutes home bias in equity portfolios. How does Home Bias work?Having a diversified portfolio of investments is crucial for investors. It means they must include different types of investments in their portfolios. These may consist of stocks, debt instruments, real estate, commodities, etc. On top of that, they must not concentrate all their investments in the same market. Due to the possibilities available, investors can build a diversified portfolio by investing in local and foreign markets. However, some investors may not believe in investing in foreign markets. As mentioned above, this bias may come from their fear of entering unknown markets or previous experiences. Due to this, investors may focus all their investments on their local markets. This bias increases their risks associated with having a portfolio that focuses on a specific market. On top of that, investors also lose the opportunity to increase their returns. Why is Home Bias important?Home bias is crucial for investors as it forces them to concentrate on a local market. Due to this, they face many risks associated with having an undiversified portfolio. As mentioned, some investors may also be active in foreign markets. Due to home bias, however, they may still dedicate a large portion of their portfolio to local investments. Identifying and avoiding home bias is also crucial for investors. Any investor active in the local markets can easily avoid this bias by considering both local and foreign investing options. Home bias can also cause investors to neglect better investment opportunities. In some cases, however, this bias can also be beneficial for investors with the returns they can get on local investments. ConclusionHome bias influences investors to concentrate their investments in local markets. By doing so, they neglect the investment opportunities available in foreign markets. This bias may arise from investors’ past experiences or fear of entering unknown markets. Home bias can lead to lost returns and undiversified portfolios. Post Source Here: Home Bias in Equity Portfolios What is Herding Behavior in Stock Market?Herding behaviour in the stock market is when investors make decisions based on other investors' investments. Other names for this behavior include herd mentality and herd instinct. Herding behavior explains investors' tendency to imitate or follow what other investors are doing. Usually, they believe that what other investors are doing will be profitable without any analysis. Herding behaviour in the stock market occurs due to several factors. These may include investors' emotions or their instinct. Without carrying any independent analysis of their own, investors may prefer imitating other investors, expecting to succeed. This phenomenon stems from behavioural finance, where it can lead to herd bias. Herding behaviour bias (or simply, herd bias) is when investors base their decisions on other investors' investments. It is a naturally occurring behaviour in humans in all fields. Herding behaviour bias leads to investment bubbles, such as the one created by Bitcoin recently. In short, herding behaviour is the tendency of individuals to confirm the actions of a larger group. How does the Herding Behavior impact investors?Investors involved in herding behaviour may experience losses. According to a report, herding bias is the highest loss-making behavioural bias for investors. Therefore, it places herding on the top of any investor's avoidance list. The herding behaviour can impact investors in one of two ways. It either exposes investors to volatility or creates a bubble in the market. Firstly, the herding mentality can cause a series of over- or under-reactions in the market. Due to the large extent of these reactions, the market suffers from volatility. On the other hand, it also creates an asset bubble. Usually, everyone in the herd assumes their decisions are rational. This herd action creates a sudden rise in the asset's price and also causes it to fall in the future. This way, it causes investors to suffer from the creation of volatility and bubbles. Why do people suffer from Herding Behavior Bias?The primary reason why individuals or investors become a part of a herd is because of their nature. Humans have long been part of the groups to survive and evolve. Similarly, humans are social animals which tempts them to be a part of the group. Therefore, their instincts entice them to follow what others are doing. Another reason for the herding behaviour is the lack of information. When investors don't analyze information on their own, they become dependent on others' decisions. Once they become a part of a group, they assume the herd has accurate knowledge to manage their investments. In most cases, the opposite applies. How to avoid Herding Behavior?In theory, it is straightforward to avoid herding behaviour. By not following what others are doing, investors can easily avoid the effects of herding behaviour. In practice, however, it is not as easy. The best way to protect against herding behaviour is to understand how it works. For example, when buying a company's stock, investors can look at how the market perceives it. Avoiding herding behaviour does not mean that investors must not invest in securities where others are investing. Instead, they must perform an independent analysis of any investment they make. This way, they can ensure they don't become a part of a herd. Even if they do, they will realize when they should leave it and not suffer losses. ConclusionHerding behaviour in the stock market occurs when investors base their decisions on what others are doing. Usually, they don't collect any information and assume the herd has accurate information regarding investments. It leads to herding behaviour bias and can cause bubbles and volatility to create. Despite that, herding behaviour is easily avoidable. Post Source Here: Herding Behaviour in Stock Market Pair trading or statistical arbitrage is a popular quantitative trading strategy. Basically, we choose a pair of assets for trading, and when the assets’ prices diverge, we bet on them reverting back to the mean. The assets are often stocks, but they can be anything, ranging from commodities, interest rate products, to exchange-traded funds. To choose a pair for trading, we often make a decision based upon,
A common question we often ask ourselves is which method is superior. We used to believe that using correlation or cointegration does not matter, as long as the pair mean reverts. However, article [1] shed some light on the matter. After conducting research, the authors concluded that choosing pairs based on cointegration resulted in superior returns, Our results confirm the weak excess returns observed in the recent publications for the minimum distance method. The trades initiated following the stationarity of the price ratio are not able to generate, after transaction costs, large and significant excess returns. The key empirical fact revealed by this study concerns cointegration. After controlling for risk factors, transaction costs and data-snooping biases, cointegration-based pairs trading exhibits high and robust positive alpha. During a period of more than 10 years, even the least profitable parameterization dealing with cointegration delivers excess returns greater than 1.38% per month. Returns can rise up to 5% per month. Cointegration reduces significantly nonconvergence risk. The article stated that cointegration reduced divergence risks, but did not explain why. This is an area for further research. Additionally, it also pointed out, If pairs trading returns are not related to the equity premium, does the volatility/Vix index matter? Do and Faff (2010) regress pairs returns against market volatility over the same month but did not find any significant effect. A new direction could analyse the influence of conditioning openings to a certain level of volatility/Vix. Based on our experience, we used to think that pair trading is implicitly shorting volatility, but as the article pointed out, this might not be the case. We look forward to new research results to learn more as to why this is not the case. References [1] N. Huck and K. Afawubo, Pairs trading and selection methods: is cointegration superior?, Applied Economics, 47:6, 599-613, 2015 Post Source Here: Cointegration or Correlation, Which Method is Better for Pair Trading? What is the Gambler’s Fallacy?The term gambler's fallacy refers to the belief that individuals have that the probability of a random event occurring in the future depends on the previous instance of that type of event. Another name used for the gambler's fallacy is the Monte Carlo fallacy. It occurs when individuals believe that the outcome of a single or several historical events influences the consequence of another event in the future. When influenced by the gambler's fallacy, individuals tend to put overreliance on the outcome of historical events. They believe that if an event has occurred frequently in the past, it will happen again in the future. However, these outcomes are usually random and not influenced by historical events. As the name suggests, the gambler's fallacy is prevalent among gamblers. How does the Gambler’s Fallacy work?In theory, for events that have a random outcome, any historical results should not be influential. Hence, making predictions based on historical results is futile. Despite that, individuals may try to establish patterns even when none exist. Based on this, they end up making decisions although they understand the randomness involved with the event. The gambler's fallacy stems from the misjudgment that investors make on a random event's outcome. Usually, the belief that random events are not truly random and may demonstrate some patterns or trends. Mostly, they use short-term information to establish this belief. In the long-term, however, investors suffer from losses due to basing their decisions on wrong opinions. How can the Gambler’s Fallacy affect decision-making?The gambler's fallacy tempts individuals to establish patterns and trends for random events. Therefore, it leads to wrong decisions made by these individuals. On top of that, by discovering such non-existent trends, individuals are likely to ignore any information opposing their beliefs. Therefore, they end up making losses when their predictions fail to realize. In some cases, a casual relationship between two events may exist. However, when individuals overanalyze this relationship, they establish a stronger dependence than what is actual. Based on this, they make decisions related to the future that involves using selective historical information. Usually, this decision follows substantial losses for individuals based on the extent of their decision. The gambler’s fallacy can also affect investors and financial decisions. For investors, having accurate and complete information about their investments is crucial. When they fail to realize that two investments are statistically independent, they will make wrong decisions. In that case, they end up suffering losses. How to avoid the Gambler’s Fallacy?The primary response to the gambler's fallacy is considering more information. One of the reasons this bias may exist is the lack of information that individuals let influence their decisions. By analyzing all available information, individuals can determine the relationships that exist between historical and future events. Similarly, establishing independence between two events also helps avoid the gambler's fallacy. It is possible to do this by either considering all information or using the critical thinking process. Individuals must also establish the reason why they believe a past event may bear a relationship with a future one. By doing so, they can recognize if they are allowing the gambler's fallacy to impact their decisions. ConclusionIn most decision-making processes, establishing a relationship between two events is crucial. However, some people may put an overreliance on a relationship when none exists. It primarily stems from the gambler's fallacy, which occurs when individuals believe the probability of a random event in the future depends on another historical event. Originally Published Here: What Is the Gamblers’ Fallacy? What is Behavioral Finance?Behavioural finance is a field in behavioural economics that deals with psychological influences and biases. It also examines how these biases impact financial behaviours that investors demonstrate. Furthermore, it studies how these behaviours affect the financial markets, such as the stock market. Behavioural finance also explains how influences and biases cause market anomalies in financial markets. Behavioural finance also comes in the form of a theory that infers investors are "normal". By stating that, it goes against some other traditional economic theories. Among other things, it also suggests that investors let biases affect their decisions. These biases may come from various sources. One of these includes the disposition effect. What is the Disposition Effect in Behavioral Finance?The term disposition effect refers to the bias that individuals have in prematurely selling assets that have made financial gains. This effect relates to flawed decisions made by individuals. The disposition effect primarily affects financial markets and investors. In that regard, it describes how investors sell securities as soon as the price rises. By doing so, they sacrifice any potential gains that they would get from holding it longer. The disposition effect seeks to explain the rationale behind how investors tend to treat unrealized gains and losses on their assets. More specifically, it suggests that investors are likely to realize gains quickly to lock them. However, they tend to hold to loss-making assets longer, hoping it would turn profitable in the future. In both these cases, the disposition effect causes losses for investors. How does the Disposition Effect work?How the disposition effect works can best be explained and understood through an example. An investor wants to free up some funds to invest in a potential high-return asset. However, they don't have the funds necessary to do so. Instead, they must sell one of the two stocks that they are holding. Both of these stocks are of the same value but have different features. When the investor bought the first stock, they expected to make significant returns in a few years. Until now, the investment has only increased slightly in value. On the other hand, the investor also bought the second stock with a similar view. However, it has suffered considerable losses since the investor acquired it. Logically, the investor would want to get rid of the loss-making stock because it can potentially amplify the losses. Similarly, they would prefer to hold onto the first stock as it can potentially increase returns. Due to the disposition effect, however, the investor chooses to dispose of the first stock. The first reason why they do so is to lock the current returns from it. On top of that, they hold onto the second stock, hoping it would turn around and be profitable. How to avoid the Disposition Effect?The best way to avoid the disposition effect is to dispose of loss-making investments in the long run. It does not suggest that investors should dispose of their assets as soon as they make a loss. However, they shouldn't stick to any investments that have suffered from losses continuously. On top of that, investors must not get rid of assets as soon as they become profitable. By doing so, they can avoid any losses and increase their gains. ConclusionThe disposition effect in behavioural finance refers to the bias that individuals demonstrate when making decisions. This effect is relevant to the financial market and investors. When investors sell profit-making assets prematurely or hold onto loss-making assets, the disposition effect comes into play. Investors can easily avoid the disposition effect by avoiding both of these circumstances. Post Source Here: Disposition Effect in Behavioral Finance What is Recency Bias?Recency bias represents the tendency of individuals to remember information that they have analyzed. While considering recent information can provide short-term results, it may neglect long-term effects. However, some people tend to allocate too much reliance to recent occurrences, which may cost them in the long run. Therefore, individuals' tendency to place an overemphasis on new information incorporates recency bias. Another name for the recency bias is the recency effect. This bias is prevalent in almost any field that involves making decisions based on historical information. It is human nature to remember and recall the most recent information and forget historical info. Hence, recency bias is an influence that occurs naturally. Recency bias also explains how individuals' memory works. How does Recency Bias work?As mentioned, recency bias depends on human memory, specifically short-term memory. This memory represents an individual's ability to hold a small amount of information for a brief period of time. However, there is a limited amount of data that it can store and a limited period for which it can do so. The more individuals delay recalling the information, the more of it they will forget. Recency bias works on the same principle. Individuals tend to remember information that they have most recently experienced. It is because that information has stayed in their memory due to being fresh. Any other relevant information may have already left their memory due to its limited capacity. On top of that, any information they have come across several times will stay in their memory for longer. In short, recency bias occurs when individuals remember any information that they have recently encountered. The more they stay away from it, the more they will tend to forget. In that case, they will be more prone to recency bias than before. However, the recency bias for each individual may differ due to their memory capacity. What are the factors that influence Recency Bias?There are several factors that contribute to how much recency bias individuals face. Usually, the type of information and its purpose play a critical role in recency bias. The more complicated the process is, the more likely it is for individuals to forget information. Therefore, the more risk of coming under the influence of recency bias is. The method the individuals use to process information also plays a role in determining the recency bias involved. Another factor that plays a significant role in recency bias is the time period for which individuals retain information. The longer this time period is, the higher their tendency is to forget information and higher recency bias. Lastly, for multitasking individuals, the recency bias may be at its highest. It is usually because these people tend to process information from multiple sources at once. Due to this, they are likely to retain a small amount of information from each source. Therefore, the recency bias for them will be higher. All of these factors depend on each individual and how their memory works. ConclusionRecency bias is when individuals tend to prefer recent information and disregard long-term info. In most cases, recency bias occurs due to individuals' capacity to hold information. The longer the period for which individuals must retain information is, the higher the chances of recency bias transpiring are. On top of that, several other factors may contribute to the level of recency bias. Post Source Here: What is Recency Bias? Many individuals dread change. Therefore, they will go through any process to prevent change from occurring. The reason why an individual may do so depends on several factors. Instead of welcoming change, these people will try to ensure things remain the same way. When these changes do occur, they view it as a loss or evil. This preference of things staying the same can lead to a bias in decision-making. What is Status-Quo Bias?Status-quo bias is a type of influence that individuals get from preferring stability over change. As mentioned, when choosing between change and conservation, they will always opt for the former. For most individuals, change comes with uncertainty, which they may not like. Instead, they strive to ensure things remain the same for the longest possible time. Status-quo bias comes as a direct result of being resistant to change. In any decision-making process, change is inevitable. However, individuals will always prefer a course that ensures there is no or minimum change involved. This way, they may end up making decisions that can lead to losses in the future. Overall, status-quo bias can lead to irrational decision-making. How does Status-Quo Bias work?Status-quo bias comes as a direct result of the change. Therefore, any process that involves change also includes the status-quo bias. The term status-quo bias comes from the work of William Samuelson and Richard Zeckhauser. They conducted various experiments which suggest that people show a substantial preference for choices that maintain the status quo. The research also suggests that when faced with critical decisions, people will prefer certainty. Therefore, they will always choose a decision that does not involve any change. While doing so can make the process shorter and more manageable for individuals, it also implies they may compromise their decision-making. Status-quo bias can entice individuals to make decisions that aren't in their best interest. By sticking to stability, individuals also sacrifice the opportunities that present themselves through change. Usually, individuals establish a default state, which they consider stable. If any decision alters this state, they will likely oppose it despite it being more reasonable. How to avoid Status-Quo Bias?Like any other type of bias recognized by behavioural finance, individuals can avoid the status-quo bias by understanding how it works. Similarly, by weighing all available options against each other and considering them objectively, individuals can reach better decisions. This way, they can avoid sticking to a default state and welcome change that accompanies opportunities. Similarly, having a plan or course of action can help in avoiding status-quo bias. This way, individuals can see the overall picture of how decisions will impact them. Furthermore, if individuals consider the losses associated with stability, they can make more informed decisions. Overall, status-quo bias is avoidable and can result in higher returns. Why is Status-Quo Bias important?Status-quo bias is important because it prevents individuals from welcoming change. Therefore, it can lead to missing out on new opportunities and sticking to a default state. Understanding this bias can help individuals prevent it from occurring. This way, they don't neglect any potential returns that they can get from otherwise embracing change. ConclusionStatus-quo bias is the type of bias that tempts individuals to prevent change from occurring. Instead, it forces them to stick to a default state. Status-quo bias can impact individuals’ decisions and lead to missed opportunities. Understanding this bias and how it works is crucial for individuals as it can help them avoid it. Originally Published Here: What is Status-Quo Bias? |
Archives
April 2023
|