Note: This article is part of ETF Trends Strategist Channel.
By Micah Wakefield
Everybody loves math, right? Such an exciting topic, said very few people ever. Many schoolchildren dislike math because they think it’s boring and they’ll never use it in the real world. I know I felt that way as a kid. This feeling generally changes somewhat for kids as they grow older and they start to have to deal with bills, paychecks, taxes, and investments. Math starts to matter.
Whether you enjoy math or not, math and statistics are key components of some of the most common and longstanding concepts in investment management such as standard deviation, the efficient frontier, correlation, and asset allocation. But for many, understanding all the math and statistics involved in investments can be a bit challenging at times and some simplification of the concepts of math is necessary.
Investors often feel this way as it relates to all things math and finance; “just please simplify it where I can actually understand it.” There is a need today to break down and simplify some of the important math concepts in finance and especially equity investments in order to be able to grasp and understand how they can be applied to investing.
This is a challenge in today’s environment, as there seems to be an engrained mindset amongst most investors today toward equity investments and returns; perhaps formed by a lack of understanding about how mathematical principles impact investing. What is this engrained mindset that most investors have today? They tend to get stuck on return, especially near-term return. This is apparent from their expectations, reactions, emotions, and choices when it comes to investing. Shortsightedly, it’s usually the first and last thing that is considered when making investment decisions.
Although we know that there are other asset classes to consider besides equities, it is still a widely accepted practice for equities to be a large portion of investor’s portfolios. Almost all portfolio allocations have at least 30% to 90% in equities, from conservative to aggressive investors. For hundreds of years, investors have looked to equities to provide growth and to help offset inflation, achieve their financial goals, and prepare for retirement. This is because, over the long-term, equities have provided relatively good growth despite high volatility and downside risk.
So if equities is a good place for investment growth over the long-term, but also one of the more volatile asset classes as seen above, how should someone invest in equities and is there any approach that mathematically gives some advantages to the investor?
This topic is the focus of Swan’s latest white paper that seeks to simplify four important mathematical principles that investors need to understand in order to change how they view equities, investment returns, and what drives their equity decisions. It also reviews four different ways to invest in equities and how these mathematical principles apply to these equity approaches.
If investors understand and focus on these four mathematical principles instead of just on return and short-term outcomes, they might make better, more informed decisions as it relates to their equity investments or their investments in general. The four principles are:
- The importance and power of compounding returns
- The importance of avoiding large losses
- The importance of variance drain
- The importance of distribution of returns
Let’s take a brief look at one of these principles, variance drain.
Volatility drag, also known as variance drain, is the drain that occurs from the arithmetic return to the geometric return from volatility. Arithmetic average is just referring to the simple sum of each occurrence of return, divided by the total number in the series. Geometric or compound refers to geometrically linking each return to the next and compounding the returns.