By Marc Odo, Swan Global Investments

In a previous blog post, “The Importance of Avoiding Large Losses,” we discussed the impacts of large losses on portfolios and wealth creation. Certainly anyone who lived through the dot-com crash of 2000-02 or the financial crisis of 2007-09 is well aware of the damage losses of 30%, 40% or 50% can have on a portfolio.

What many people don’t know, however, is the impact that volatility has on the long-term success of an investment plan. If bear markets can be described as a rare but catastrophic flood, everyday volatility can be thought of as water damage slowly eroding away the foundations of your house.

Investment returns are often stated as long-term averages. The problem with averages, however, is that averages mask details. The day-to-day or month-to-month experience of an investor might be radically different from the long-term averages. What happens in-between might have a large impact on the final wealth of an investor.

Again, we start with a simple illustration. If one were asked which of the following three scenarios would yield the best ten-year results, one might be tempted to choose the last of these three options:

  1. Up 10% one year, down 5% the next, repeated for ten years
  2. Up 25% one year, down 20% the next, repeated for ten years
  3. Up 40% one year, down 35% the next, repeated for ten years

In fact, the opposite is true. After a decade:

  • Scenario A, with its most modest gains and losses, performs best and is the only scenario that is profitable;
  • Scenario B breaks even and;
  • Scenario C loses money.

This phenomenon is known as volatility drag. Also called variance drain, volatility drag was detailed in a 1995 paper by Tom Messmore titled “Variance Drain – Is your return leaking down the variance drain?”. Messmore observed that the more variable a given asset’s return is, the greater the difference between the arithmetic and geometric returns.

  • Arithmetic mean is the average of a set of numerical values, calculated by adding together and dividing by the number of terms in the set (Source: Wikipedia).
  • Geometric mean is defined as the value of a set of numbers by using the product of their values, as opposed to the arithmetic mean which uses their sum (Source: Wikipedia).

Formula of Variance Drain

This formula shows that the variance of returns “drains” the arithmetic average returns to produce the smaller, realized, compound returns (Source: Decker, Robert: The Variance Drain and Jensen’s Inequality).

Why does this matter for investors?

It ties back to our previous posts on compounding returns and minimizing losses.

In order to optimally take advantage of the power of compounding, investors must avoid large losses and recoveries requiring exponential growth. In addition, investors must also avoid the negative power of compounding by seeking to lower volatility and variance drain as best as possible.

The table below shows different scenarios with the same arithmetic annual return (i.e. 10%) but coupled with different levels of volatility.

Generally speaking, there are two rules of thumb to remember when it comes to volatility drag.

  1. The higher the level of volatility, the more detrimental the impact of volatility drag, as evidenced in the table above.
  2. The longer the time period, the bigger the negative impact will be.

This situation is also explored in a post on volatility we recently wrote for ETFTrends.com. In addition, the greater the volatility, the more unlikely it is that an investor will be able to “stay the course” and stick with an investment or strategy.

We can see how these factors all tie together in their mathematical application within an investor’s portfolio: compounding, avoiding large losses, and now volatility. Compounding, whether negative or positive, is the common thread throughout all of them. As a recap, the four key mathematical principles outlined in “Math Matters” are:

  1. The importance and power of compounding
  2. The value of avoiding large losses to returns
  3. The importance of variance drain
  4. The value of a non-normal distribution of returns

Marc Odo is the Director of Investment Solutions at Swan Global Investments, a participant in the ETF Strategist Channel.

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