Portfolio volatility has a large negative impact on investment performance and is one of the major reasons investors’ long term returns fall far short of expectations. I’m going to demonstrate why managing portfolio volatility is critical to your investment returns and crucial to managing investment risk.
Impact on Performance
Most people calculate an arithmetic return, which is a simple average over over a period of years. Fund managers and mutual funds report arithmetic returns. It is the same formula the media reports for returns on market indices. Most investor portfolio returns fall below reported averages because arithmetic returns do not reflect the real or actual impact on portfolio performance.
A negative 50% return and a positive 50% return would have an average return of 0% or break even. But the real impact on performance is a combined 25% loss. It doesn’t matter the order of the returns. A 50% positive return and a 50% negative return is also a 25% loss.
Examples of Portfolio Volatility
Let’s look at this example of 3 portfolios over a period of 6 years. All three portfolios have an average return of 5% over the 6 year period. Portfolio B experiences 10% more volatility each year than portfolio A; both in the up and down years. Portfolio C experiences 25% more volatility than Portfolio A.
Portfolio A B C
Year 1 +5% +15% +30%
Year 2 +5% – 5% – 20%
Year 3 +5% +15% +30%
Year 4 +5% – 5% -20%
Year 5 +5% +15% +30%
Year 6 +5% – 5% -20%