The Undercurrents of Volatility

In the world of investing, understanding the forces that shape returns is crucial for long-term success. One such force, often overlooked by investors, is volatility drag.

This phenomenon, inherent in the fluctuating markets, plays a pivotal role in determining the actual returns on investments, diverging from what simple arithmetic averages might suggest.

Volatility drag refers to the effect that the volatility of investment returns has on the compounded growth rate of a portfolio.

It underscores a fundamental investment principle: the path an investment takes matters just as much as its average return.

Consider this – an investment that experiences wild swings, even if it boasts a high average return, may end up with a lower compounded return compared to a steadier investment. This is because losses have a more substantial impact on portfolio value, requiring greater gains to recover. 

Therefore, when evaluating investment opportunities, savvy investors look beyond mere average returns. They consider the volatility of an investment, understanding that it can significantly erode compounded returns over time.

The concept of volatility drag is not just an academic curiosity; it's a practical concern that influences investment strategy and portfolio management.

By taking into account the volatility of an investment in addition to its return potential, investors can make more informed decisions, aligning their strategies with their risk tolerance and long-term goals.

The Mathematics of Volatility Drag

Investing is not just about picking assets with the highest potential returns; it's equally about understanding the journey those returns will take.

This journey, characterized by ups and downs, significantly influences the final outcome of an investment due to a concept known as volatility drag.

At its core, volatility drag is a consequence of the mathematical difference between geometric and arithmetic returns.

• Arithmetic returns, the simple average of periodic returns, do not account for the compounding effect present in real-world investing.

• In contrast, geometric returns, which consider the compounding effect, provide a more accurate depiction of an investment's performance over time.

To illustrate, imagine two scenarios where an investment has an arithmetic average return of 10% over two periods. Say, you invest $100.

In the first scenario, the investment gains 30% in the first period and loses 10% in the second. You end up[ with $117 in your account.

In the second scenario, it gains 10% in both periods. You end up with $121.

While the arithmetic average return is the same in both cases (10%), the geometric return tells a different story due to the impact of volatility. You’re better off from a total wealth standpoint in choosing the less volatile investment.

The investment with consistent gains ends up with a higher compounded return, demonstrating how volatility drag can erode the value of more volatile investments.

This mathematical principle highlights the importance of examining an investment's volatility alongside its potential returns.

A higher volatility not only increases the risk but also affects the compounded return due to volatility drag. Investors must navigate these waters carefully, balancing the lure of high returns against the potential downsides of volatility.

By recognizing the difference between arithmetic and geometric returns, investors can better assess the true potential of their investments, taking into account both the upsides and the downsides.

Implications of Volatility Drag on Investment Performance

Volatility drag is more than a mathematical curiosity; it's a real-world force that can significantly affect the growth potential of investments. Understanding its implications is essential for anyone looking to build wealth over the long term.

The impact of volatility drag on investment performance becomes particularly evident in markets characterized by high volatility. In such environments, the compounded returns of investments can diverge substantially from what investors might expect based on average returns alone.

The essence of volatility drag lies in the asymmetric nature of gains and losses.

A loss requires a disproportionately larger gain to recover, a principle that becomes increasingly punitive with higher volatility.

For instance, a 50% loss in an investment's value requires a 100% gain just to break even. In volatile markets, where dramatic swings are more common, this recovery process can severely hamper compound growth.

This presence of volatility drag has profound implications for portfolio management and investment strategy.

• First, it highlights the importance of minimizing losses through prudent risk management techniques such as diversification and careful asset selection.

• Second, it underlines the need for investors to consider the volatility of their investments as a critical factor in their decision-making process. Investments with lower volatility may offer more consistent compounded returns over time, even if their average arithmetic returns are not the highest.

A Wealth Accumulation Example

Let’s assume that you have two potential investments with the same expected average rate of return of 10% per year.

Further, assume that the first investment has an expected volatility or standard deviation of 20% per annum. The geometric return after we account for volatility drag is 7.9% per annum. Let’s call this the High Vol investment.

The second investment has an expected volatility of 12% per annum. The geometric return accounting for volatility is higher at 8.6% per annum. We call this the Low Vol investment.

Without the benefit of a crystal ball the best we can do is simulate what is likely to happen in the future. Our planning horizon is assumed to be 10 years. We start with a $1 investment.

Assuming that these investment returns follow a log-normal distribution (a standard use in academic finance), we observe the following hypothetical scenario

High Vol Investment

• The geometric return of 7.9% is the middle of the distribution outcome for annual returns. It’s the median return as shown in the diagram.

• As we know in any given year returns can be all over the map. For example, in Year 1 we could see a 45.6% return (95th percentile), or a loss of 19.6% (5th percentile)

• As time passes we would expect the average realized return to get much closer to the 7.9% geometric average. That’s why the return bands shrink over time.

• In terms of portfolio wealth which is what people ultimately care about, the range of potential outcomes grows with time due to the compounding effect.

• The median expected value of our High Vol portfolio after 10 years is $2.2.

• On the very lucky side (95% percentile) the portfolio grows to $5.63 by year 10, but if we are cursed by bad luck (5th percentile) our portfolio would shrink to $0.86.

• This is where you can see the effects of volatility. It acts similar to leverage. Volatility can significantly enhance wealth. but it can also result in a meaningful reduction.

Low Vol Investment

• The geometric return of 8.6% is the middle of the distribution outcome for annual returns.

• This median return is higher than for the High Vol option given the lower volatility of this investment

• The Year 1 return could be between 36.3% (95th percentile) and -12.8% (5th percentile)

• Compared to the High Vol investment, the range of returns is much more compressed both on the upside as well as downside

• The median expected value of our Low Vol portfolio after 10 years is $2.37. This compares to an ending value of $2.2 for the High Vol option.

• If we get super lucky the portfolio will grow to $4.79 but if we get unlucky the portfolio will only grow after 10 years to $1.17.

• Compared to the High Vol investment the range of wealth outcomes is more compressed.

• If we get lucky, the High Vol investment makes more money ($5.63 compared to $4.79)

• Conversely, if we do get unlucky we end up losing money with the High Vol investment (loss of $0.14) while with the Low Vol option, we end up making $0.17.

Takeaways from this example:

Understanding the implications of volatility drag should prompt investors to reevaluate their strategies, especially in highly volatile markets.

It encourages a shift from merely chasing high average returns to seeking investments that offer a favorable balance between return potential and volatility. This balanced approach aims to mitigate the impact of volatility drag, thereby enhancing the long-term growth of the portfolio.

Moreover, the awareness of volatility drag's effects helps investors set more realistic expectations for their investment outcomes. It emphasizes the significance of long-term planning and the value of patience in investing.

Volatility Drag and Investor Behavior

The concept of volatility drag extends beyond mathematical formulas and investment strategies. It also influences investor behavior and decision-making.

Awareness (or lack thereof) of the effects of volatility drag can lead investors down very different paths, shaping their reactions to market changes, risk assessment, and ultimately, their investment success.

Impact on Decision-Making

Investors informed about volatility drag tend to approach investment decisions with a more nuanced perspective. Understanding that high volatility can erode returns over time, these investors might prioritize stability and long-term growth over short-term gains. This knowledge encourages a more disciplined investment approach, focusing on consistent performance and risk management.

Conversely, investors unaware of volatility drag may be more inclined to chase high-return investments without fully considering the risks associated with volatility. This pursuit can lead to overexposure to risky assets, making their portfolios more susceptible to significant downturns.

The allure of high arithmetic returns can overshadow the potential for compounded losses, leading to decision-making that prioritizes potential gains over stability and long-term growth.

Behavioral Biases

Volatility drag also plays into various behavioral biases that can cloud investor judgment.

For example, the recency bias, where investors give more weight to recent events than historical trends, can lead to overconfidence in volatile markets. When recent performance has been favorable, investors might underestimate the risk of future volatility and its impact on returns.

Similarly, the loss aversion bias, where the fear of losses outweighs the pleasure of gains, can lead to premature selling during downturns, locking in losses and exacerbating the effects of volatility drag on portfolio performance.

Risk Assessment

A deep understanding of volatility drag contributes to a more accurate risk assessment.

Investors should see volatility not just as a measure of risk but as a direct factor affecting their portfolio's compounding ability.

This perspective encourages a more holistic view of risk, combining traditional metrics with considerations of how volatility affects compound returns over time.

Strategies to Mitigate Volatility Drag

Mitigating the effects of volatility drag is essential for investors aiming to maximize their portfolio's long-term growth potential.

Here are practical strategies that can be incorporated into your investment approach to counteract the negative impact of volatility drag.

Diversification

By spreading investments across various asset classes, sectors, and geographical regions, investors can reduce the risk of significant losses from any single investment.

Diversification helps in smoothing out the returns, as the positive performance of some investments can offset the negative performance of others.

This balanced approach reduces portfolio volatility, thereby minimizing the drag on compound returns.

Asset Allocation

Careful asset allocation is crucial in managing volatility.

By allocating investments according to one's risk tolerance, investment horizon, and financial goals, investors can achieve an optimal balance between risk and return.

Adjusting the proportion of equities, bonds, alternatives, and cash in the portfolio can help in controlling volatility. For instance, bonds typically exhibit much lower volatility than stocks and can provide a stabilizing effect on the portfolio during turbulent market conditions. Cash serves the same purpose even though, under most market environments, it is a drag on portfolio returns.

Investing in Low-Volatility Strategies

Investors concerned about volatility drag can consider low-volatility investment approaches. These approaches, designed to provide steadier returns, can be less susceptible to large swings in value, thus reducing the potential for volatility drag.

• Lower Volatility Stocks: Typically larger capitalization equities in mature industries. Good candidates are pharma, consumer staples, and utilities.

• Dividend-Paying Stocks: Dividends act as a buffer when things get rough in the stock market. Typically dividend payers are lower volatility and have less exposure to the overall market movement (lower beta). High-dividend stocks are to be avoided due to the possibility of dividend cuts.

• Low-Vol Smart Beta Exchange Traded Funds: These funds were at one time very popular but lost some cache during the COVID-19 meltdown when they did not protect the downside as much as advertised. These ETFs have sector exposures quite different from those of broad-based indices such as the S&P 500 or Russell 1000.

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