What is Horizon Analysis?
Horizon analysis compares the projected discounted returns of a security or investment portfolio’s total returns over several time frames or investment horizons.
Key Takeaways
- Horizon analysis assesses projected returns over various time frames; these are often called investment horizons.
- It’s typically used to predict the performance of portfolios containing fixed-income securities (bonds).
- This method allows portfolio managers to assess which bonds would perform best over the designated investment horizon.
Understanding Horizon Analysis
Horizon analysis leverages scenario analysis to create a more realistic expectation of an investment’s performance. Generally, this is applied to portfolios comprising fixed-income securities.
The horizon analysis framework enables portfolio managers to forecast the performance of bonds based on the planned investment horizon and various factors such as risk levels, interest rates, reinvestment rates, and future market yields.
Breaking down expected returns into scenarios allows for assessing which bonds might perform best over the planned investment horizon. This is something that simpler calculations, such as the yield to maturity (YTM), may not provide. Scenario analysis helps in determining how sensitive a bond’s performance is to each scenario, aiding the portfolio manager to meet investors’ goals over their expected investment horizon.
Horizontal Analysis
Horizontal analysis is a similar term used in financial statement analysis to compare historical data, such as ratios or line items, over several accounting periods.
Investment Horizons and Portfolio Construction
When investors have a longer investment horizon, they can generally take on more risk, as the market has more time to recover from potential downturns. For instance, an investor with a horizon of 30 years would typically allocate most assets to equities.
A long-term investment horizon allows for riskier equity investments, such as mid-cap and small-cap stocks. These stocks often demonstrate larger short-term price swings compared to large-cap stocks due to their smaller size and vulnerability to external economic factors. However, the impact of such fluctuations should be minimal for those aiming to hold these investments for decades.
As the investment horizon shortens, investors usually adjust their portfolios to reduce risk. For example, retirement portfolios often shift away from equities toward fixed-income assets as retirement approaches. Fixed-income investments usually offer lower long-term returns compared to stocks but ensure greater stability due to less pronounced short-term price swings.
Related Terms: scenario analysis, yield to maturity, financial statement analysis.
