Trustworthy the scoring procedures can be used for the identification of properties that will benefit from a short term investment. These procedures are based on the assumption that a higher score means that the investment is more reliable. This is a generalization, as not all investments and portfolios show the same correlation with subsequent performance. Nonetheless, it is a useful starting point for any investor. It can be used by real estate agents, banks, pension funds, insurance companies and other financial institutions.
A trustworthy pre scoring model assumes that future performance will follow a similar pattern to the performance of the portfolio. This assumption is based on the assumption that changes in portfolio holdings will have a direct effect on subsequent returns. The model also assumes that future returns will depend on factors that cannot be currently identified. These include historical performance of the selected portfolios and bond rates.
As stated earlier, most investors find trustworthy pre scoring models intuitively appealing. Unfortunately, it is not always clear from the start how to select models with high accuracy. There are a number of problems with the standard deviation as a measure of portfolio risk, which are discussed below. When these problems are understood, the problems associated with the standard deviation can be addressed.
The standard deviation is a bell-and-whistle indicator for market risk, which is very sensitive to movements in portfolio holdings. As portfolio holdings move up or down in value, this deviation shows up as an oscillating pattern, with the tails varying in length. If the investor only monitors short-term returns, it will be very difficult to detect subtle trends that will eventually affect returns. Even if the investor is able to detect short term oscillating trends, it is likely that the longer-term trends will be unaffected by short-term fluctuations. In addition to providing unreliable long-term forecasts, the deviation is also influenced by other factors such as portfolio size and asset allocation strategies.
As mentioned earlier, the purpose of a pre-scoring model is to identify the viability of a particular portfolio investment strategy. Although it is possible to discover reliable outputs from these models, they are not without weaknesses. For example, the portfolio equity component of a model is based on a limited number of correlated portfolio assets which typically include very low quality stocks. While these assets do not have strong predictive power, they can still be used as part of a portfolio optimization strategy which does not take into account the potential non-linearity of the portfolio.
Many investors are comfortable with the idea of using trustworthy the scoring models. However, it is important to realize that the reliance upon these types of models actually increases the volatility of the portfolio. Since the outputs generated by these models rely on the non-linearity of the portfolio, it is very easy for returns to deviate from expectations. As a result, many times the investor may not notice a large deviation but instead will find that portfolio performance has actually been worse than anticipated. As a result, portfolio owners tend to focus their attention elsewhere.
An additional disadvantage of trustworthy pre scoring models is that the models often fail to take into account the randomness of distribution. As a result, the models cannot adjust for the non-linearity of portfolio behavior and therefore provide estimates that are only approximate. Thus, even when using trustworthy the scoring models, it is important to remember that they do not provide an accurate picture of portfolio behavior. They do, however, help managers to reduce the potential for costly mistakes.
So can trust the scoring models replace historical averages? In most cases, no. While a trusted the scoring model can certainly guide portfolio decisions, the historical averages can still be useful for calculating risk and asset allocation.