Volatility .. the hidden killer of returns

🤔 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.

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.

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.

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.

Till next time,

Sumeet @ InverseWealth

The Fine Print

This content is for educational purposes only. Not investment advice. Do your own due diligence and consult with a professional before making any decisions.

All performance figures shown are hypothetical and not from an actual trading account. Returns do not account for fees, trading costs, taxes, or other expenses that would reduce real-world performance. All investing involves risk, including loss of principal. Past performance is not a guarantee or indication of future results.