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A trading effect is a way for investors to measure the impact of their various market trades on their overall portfolios. This is done by measuring a trade or a series of trades against some industry benchmark to see how they compare. For stocks, the S&P 500® is commonly used as benchmark, while bond traders can use the Dow Jones Corporate Bond Index as their basis for comparison. Using the trading effect can be an effective way to judge the performance of mutual fund managers, portfolio managers, or even the investors themselves if they are responsible for choosing their own trades.
Measuring the performance of the various investments and transactions made is a necessity for a good investor. Without knowing how their different investments are stacking up against others of the same type, investors could be losing their competitive edge in the market. Even when investments are making money over time, they can still be problematic if they aren't performing as well as other assets and securities. One way to keep track of the performance of an investment or a series of them is to use the trading effect.
The key to the trading effect is the use of benchmarks. There are benchmarks that exist for just about every type of investment, and they can be chosen based on how narrow the investor wants to be with his or her comparison. For example, an investor who buys stocks might wish to simply consult the S&P 500® as the index which will serve as the benchmark. If the investor focuses on stocks with small market share, however, he or she might wish to choose an index that tracks the performance of those specific stocks.
Once the benchmark is chosen, the investor simply has to compare the performance of his or her investments against the benchmark. As an example, an investor who buys bonds chooses a bond index that has gone up by 10 percent over the course of a year. Over the same time period, the bond portfolio owned by the investor has risen just eight percent. In this case, the trading effect is negative, and the investor, even though he is making money, is falling short of the average.
There are many different applications for the trading effect. An investor in a mutual fund might use it to track the performance of the fund manager's investment choices. Other investors turn their entire portfolios over to investment professionals, and this technique can be effective for judging their performance as well.