10 Most Difficult Trading & Investing Concepts to Master
In trading and investing, there are many concepts and strategies that can be difficult to grasp, especially for beginners.
To be a successful trader or investor, it’s important to understand these complex concepts and learn how to apply them to your investing strategy.
In this article, we will explore some of the most challenging concepts in trading and investing, and discuss why it is essential to master them.
- Understanding the concept of what’s discounted in markets is important for traders/investors, as it implies that all known information is already reflected in the price of securities. Relying solely on widely available information or following the news is unlikely to consistently outperform the market.
- Investors should focus on real (after-inflation) returns rather than nominal returns to preserve or enhance their purchasing power over time. Considering inflation, taxes, and all-in costs and risks helps investors accurately assess the true growth of their investments.
- Risk management, portfolio diversification, and asset allocation are essential for maintaining a well-balanced portfolio that can withstand market fluctuations and protect wealth. Margin trading can amplify returns but comes with significant risks, requiring a thorough understanding of the associated risks and rewards.
What’s Known Is Already Priced In
One of the most difficult concepts to understand is that all known information about a security is already reflected in its price.
Relative to discounted expectations
For example, most people think that if the economy is bad, this is bad for the stock market, so they sell.
However, markets don’t go down because things are bad, but because things are bad relative to what’s discounted in.
Things can be bad, but markets can still rally because what transpired was better than what was already baked into the market pricing.
Likewise, you can be in a part of the cycle where nominal growth is very high yet markets decline.
In such cases, this is when central banks start raising interest rates faster than discounted into markets and growth rates begin to disappoint relative to consensus.
It’s common to extrapolate the good times when the opposite is more likely.
This frequently causes market outcomes different from the ones expected, leading to lots of confusion.
This means that it’s very hard for an investor to consistently outperform the market by using any information that is publicly available.
Investors need to keep this in mind when developing their strategies, as simply following the news or relying on widely available information is unlikely to lead to market-beating returns.
This is not implicitly an argument for what’s popularly known as the Efficient Market Hypothesis (EMH). It’s not an argument for markets being efficient per se but rather the difficulty in any individual trader producing alpha over the long-run.
Following from what’s written above, it’s analogous to trying to bet horses at the racetrack.
It doesn’t necessarily pay to just bet the best horse or whatever is most fashionable because their implicit odds are reflected in their market odds.
For example, if the betting favorite is at 1/3 odds (bet $3 to win $1) and the longshot is 50/1 (bet $2 to win $100) and the favorite legitimately has a 75% chance to win the race and the longshot has a 2% chance, then both are equally good bets.
This is reflected in the expected values of the bets. That is, their odds match their implied probabilities.
On the other hand, if the longshot actually had a 3% chance to win the race, betting on the longshot would be the better bet (assuming you could cover the loss) because you now have positive expected value.
Even though there’s still a 97% chance that you’re wrong, if you do enough positive expected value bets over the long-run, you’ll surely have winning results.
In that particular case:
Expected Value = 0.03 * $50 – 0.97 * $1 = +$0.53
In other words, for every $1 you bet, you have +$0.53 in expected value, so this is a good bet even though the most likely outcome is that you’ll be wrong.
Opportunity cost refers to the potential benefits an investor misses out on when choosing one investment over another.
It is essential to consider opportunity costs when making investment decisions, as the attractiveness of a potential investment should be weighed against the alternatives.
Understanding opportunity cost helps investors avoid making poor investment choices that could have negative long-term consequences.
Focus on Real (After-Inflation) Returns, not Nominal Returns
Many investors focus on nominal returns, or the absolute increase in the value of their investment.
However, what truly matters is the real return, which takes into account the impact of inflation on purchasing power.
Focusing on real returns helps investors ensure that their investments are growing at a rate that will preserve or enhance their purchasing power over time, rather than simply keeping up with inflation.
Remember that the fundamental purpose of an investment is to, at minimum, preserve the holder’s purchasing power over time.
Another important concept is understanding the importance of after-tax returns.
Taxes can significantly impact investment returns, and different investments may be taxed at different rates.
Investors need to consider the tax implications of their investment choices and factor them into their decision-making process to ensure they are making the most tax-efficient choices possible.
Neglecting to Consider the All-In Costs
For many, they think the returns on their house are the nominal returns.
However, following what’s said above in the after-inflation returns section, there’s an inflation rate.
There are also holding costs.
So, if someone were averaging 3% nominal returns on a house over the long run, and their inflation rate was also 3%, their real returns were 0%.
Then if they factor in their costs, they’re negative.
For someone who owns a rental property and wants positive real returns, they’re going to calculate to make sure that the sum of their nominal appreciation and rental income is higher than the sum of the losses in buying power due to inflation and their expenses.
Then account for taxes.
Doing this math will help them determine what kind of rent they can reasonably charge.
Not Taking Into Account Their All-In Risks
For example, let’s say a US investor owns a CAD-denominated bond in a Canadian oil company yielding 4%.
Most of those who don’t have any financial training think the return is simply the 4% annual yield.
However, it neglects the following that can have an adverse impact on returns:
- Domestic inflation rate
- Interest rate risk
- Credit risk
- Foreign currency (FX) risk
- Opportunity cost of putting your money somewhere else
For simplicity, let’s say that it’s held to maturity, so no interest rate risk.
Let’s say one’s domestic inflation rate is 5% over the bond’s life, the borrower doesn’t default over the life of the bond, the foreign currency lost 3% per year against the USD, and you have a tax rate of 20%.
Your real return is the after-tax yield minus costs related to inflation and the FX.
Real Return = 4% (1-0.20) – 5% – 3%
Real Return = 3.2% – 5% – 3% = minus-4.8%
So they think they’re getting 4% when in reality, if they take into account all their risks, they lost money holding it.
This is why it’s imperative to understand one’s risks and expenses.
Even with a very simple investment like domestic cash, they’re getting taxed on the interest and need to take into account their inflation rate.
So, they need to look at their after-tax income relative to the rate of inflation.
Risk management is the process of identifying, analyzing, and prioritizing risks in a portfolio and taking steps to mitigate them.
This is a critical skill for investors, as it helps them maintain a well-balanced portfolio that can withstand market fluctuations and protect their wealth over the long term.
Effective risk management requires a deep understanding of market dynamics, asset correlations, and individual investment risk profiles.
Portfolio Diversification & Asset Allocation
Margin trading is the practice of borrowing money from a broker to buy securities, with the securities serving as collateral.
This can be a powerful tool for investors, allowing them to amplify their returns by leveraging their investments.
However, margin trading is often poorly understood, and the expected returns on the asset being leveraged are frequently less than the interest being paid on the margin.
This can lead to significant losses not only a yield basis but a price basis (if the asset falls) if not managed carefully, making it critical for investors to fully understand the risks and rewards of margin trading before engaging in this practice.
How do I know if the Efficient Market Hypothesis (EMH) applies to my investments?
The EMH applies to varying degrees across different markets and asset classes.
It is generally more applicable to developed markets with high levels of liquidity and transparency, such as major stock exchanges.
For example, the US stock market tends to be a difficult market to create alpha in because of all the market participants in it and analyzing it.
However, less efficient markets, like those with limited information or trading opportunities, may present more opportunities for investors to exploit mispricings.
It’s essential to understand the market dynamics and efficiency levels for the investments you’re considering.
How can I calculate the opportunity cost of an investment?
To calculate the opportunity cost, compare the potential returns of the investment you are considering with the returns of the best alternative investment.
This requires researching various investment opportunities and estimating their potential returns, taking into account factors such as risk, liquidity, and time horizon.
What is a good way to measure real (after-inflation) returns?
A common way to measure real returns is to subtract the inflation rate from the nominal return.
For example, if your investment returned 8% and the inflation rate was 3%, the real return would be 5% (8% – 3%).
This gives you a more accurate picture of how much your investment has grown in terms of purchasing power.
How can I optimize my after-tax returns?
Optimizing after-tax returns involves considering the tax implications of your investments and making tax-efficient choices.
This may include investing in tax-advantaged accounts like IRAs or 401(k)s, holding investments for longer periods to qualify for lower long-term capital gains tax rates, or choosing tax-efficient investments like municipal bonds or index funds.
What are some practical steps to implement risk management in my portfolio?
Implementing risk management in your portfolio involves several steps:
- Identifying risks: Evaluate the potential risks associated with each investment in your portfolio.
- Analyzing risks: Determine the likelihood and potential impact of these risks on your portfolio.
- Prioritizing risks: Rank risks based on their potential impact and likelihood.
- Mitigating risks: Develop a plan to address these risks, such as diversifying your portfolio, adjusting your asset allocation, or using risk management tools like options.
How do I determine the right level of diversification and asset allocation for my portfolio?
The ideal level of diversification and asset allocation depends on your investment goals, risk tolerance, and time horizon.
Start by determining your risk tolerance and investment objectives, then research different asset classes and their historical performance to understand their potential returns and risks.
Finally, create a diversified portfolio that aligns with your objectives and risk tolerance, adjusting the asset allocation as needed over time to maintain the desired balance.
What are the main risks associated with margin trading, and how can I mitigate them?
The main risks associated with margin trading are leverage risk and margin call risk.
Leverage risk arises when the borrowed funds amplify losses, leading to potentially significant losses if the investment’s value declines.
Margin call risk occurs when the value of the collateral falls below the broker’s requirements, forcing the investor to either deposit additional funds or sell the assets.
To mitigate these risks, ensure you have a deep understanding of the assets you are trading, and closely monitor your margin account to prevent margin calls.