Volatility .. the hidden killer of returns
Learn how volatility drag reduces wealth.
🤔 Which portfolio would you pick?
Let’s say you had a choice between 2 investment portfolios.
Slow & Steady portfolio: Grows consistently at 10% a year. Nice and easy. No drama.
Fast & Furious portfolio: Offers a phenomenal 30% return in Year 1. Then a -10% pullback in Year 2.
Investment Returns | Slow & Steady | Fast & Furious |
|---|---|---|
Year 1 return | 10% | 30% |
Year 2 return | 10% | -10% |
Which portfolio would you pick? (Don’t cheat and scroll down .. think about it for a minute 🙂 )
Note: The ‘average’ (arithmetic) return on each portfolio is exactly the same @ 10%. You may be forgiven for wondering if it even matters.
✅ Yes, Volatility definitely matters
The average return for both portfolios is the same @ 10%.
However, the nature of compounding creates very different outcomes.
Let’s say you started with $100,000.
Slow & Steady | Fast & Furious | |
|---|---|---|
Year 1 outcome | $100,000 × 1.1 = $110,000 | $100,000 × 1.3 = $130,000 |
Year 2 outcome | $110,000 × 1.1 = $121,000 | $130,000 × 0.9 = $117,000 |
Total return | 21% | 17% |
Surprise!
‘Slow & Steady’ outperformed the more volatile ‘Fast & Furious’.
Even though the average return of these portfolios is exactly the same!
This phenomenon of volatile portfolios underperforming is called Volatility Drag.
⚓️ Volatility Drag - and why it reduces returns
Volatility reduces returns due to three reasons:
In real life, returns are compounded (i.e. multiplicative) and not additive.
Losses therefore hurt more than the gains can help.
eg: If you go down by 50% in Year 1, you need to gain 100% in Year 2 just to break-even .. ouch!
As a consequence, large swings reduce the actual return compared to the average expected return.
Minimizing volatility & reducing losses can have a big impact on your long-term wealth - everything else being equal.
For inexperienced investors, this is often NOT intuitive. Understanding this concept is therefore critical for building long-term wealth.
Let’s see how this plays out over longer horizons.
In the example below, we simulate a $100,000 investment across two portfolios that have the same average return of 10%, over 10 years.
The only difference is that ‘Slow & Steady’ is extremely consistent. While ‘Fast & Furious’ is a rollercoaster.
Fast & Furious | Slow & Steady | |
|---|---|---|
Year 1 | -20% | +10% |
Year 2 | +25% | +10% |
Year 3 | -10% | +10% |
Year 4 | +22% | +10% |
Year 5 | -5% | +10% |
Year 6 | +28% | +10% |
Year 7 | +20% | +10% |
Year 8 | -15% | +10% |
Year 9 | +27% | +10% |
Year 10 | +28% | +10% |
The chart below shows the outcome after 10 years.
‘Fast & Furious’ compounds much slower than ‘Slow & Steady’, due to volatility drag 🤯.
In 10 years:
‘Slow & Steady’ would return $259,374
‘Fast & Furious’ would return $221,385
A difference of about $40,000 (17%).
Even though ‘Fast and Furious’ has several monster years, it simply fails to catch up with the consistent ‘Slow & Steady’.
📈 Practical Implications for investors
Most investors tend to chase recent performance. When thinking about 10-20 year investment horizons however, we believe that volatility is equally important.
Portfolios with seemingly modest returns & lower volatility, can outperform portfolios that appear to have more appealing returns, but higher volatility.
It’s counter-intuitive, but in the long-run, slow and steady actually wins. With a lot less drama.
It’s also important to realize that sticking to ‘Slow & Steady’ is not easy in real-life. FOMO is real, especially when you see ‘Fast & Furious’ on a big high.
But the rewards are greater for those that are patient and disciplined.
About InverseWealth
At InverseWealth, we apply these concepts to construct long-term portfolios for clients.
Our approach aims to grow our clients’ wealth steadily. With less ups and downs. Through boom or bust environments.
Request a call to learn more.
Sumeet Ganju Sumeet Ganju is the founder of InverseWealth, a fee-only fiduciary RIA, where he helps tech operators and founders turn concentrated equity into lasting wealth. He writes here most Sundays.