Should you worry about the volatility of asset returns as a long-term investor? Yes, you should, because it will cost you money over time. People tend to only look at arithmetic returns of an investment, meaning the return in a specific period. Instead, investors should look at geometric or compound returns as it takes volatility of returns into account which are drag on your returns.
This is known as volatility drag: the higher the volatility of returns of an asset, the higher the drag on the geometric return. Higher volatility leads to lower geometric average returns due to compounding effects. Compounding not only affects the returns of an asset but also its volatility. This phenomenon is particularly important for long-term investors and highlights the value of strategies that aim to reduce portfolio volatility while maintaining returns.
Consider the following example:
| Asset |
Year 0 |
Year 1 |
Year 2 |
| Asset A Value |
100 |
110 |
121 |
| Annual return |
10% |
10% |
|
| Avg. annual return over 2 years |
10% |
||
| Asset B Value | 100 | 60 | 96 |
| Annual return | -40% | +60% | |
| Avg. annual return over 2 years | 10% |
This example shows why looking at arithmetic returns only ignores volatility:
- Asset A returns 10% in year 1 and 10% in year 2 and has an average return over the 2-year period of 10% resulting in a value of 121 for asset A.
- Asset B also has an average return over the 2-year period of 10%. However, due the volatility of the returns in year 1 (-40%) and year 2 (+60%) the value of asset B at the end of the 2-year period has dropped to 96.
Volatility is impacting returns due to the asymmetry of gains and losses. A loss of 50% requires a gain of 100% to offset the loss. To visualize what this means assume you have an asset without drift, meaning the asset price is not expected to move up or down over time. In this example we look at an asset with 0%, +/-5%, +/-10%, and +/-30% volatility.
- 0% volatility means, the asset price does not change over time.
- +/-5% volatility means, the asset price increases 5% tomorrow, decreases 5% the day after tomorrow, and so on.
This is how your returns will look like with various levels of volatility:
Even though there is no drift, simply due to the volatility of returns the strategy will lose money over time due to the volatility drag. The higher the volatility, the bigger the impact on the asset returns, due to the asymmetry of gains and losses.
Next, assume an asset hat has a positive drift, meaning a positive expected return of 5% over time again with various levels of volatility:
Again, it is obvious how volatility drags down returns over time and this shows why lower volatility assets are better for long-term portfolio growth. This is why diversification is so powerful.
The following table shows the “true” returns over time using the Compound Annual Growth Rate (CAGR). CAGR is a measure of an investment’s average annual growth rate over a specified time period, taking into account the effect of compounding:
|
Scenario 1 |
Scenario 2 | Scenario 3 |
Scenario 4 |
|
| Edge |
5% |
5% | 5% | 5% |
| Volatility | 0% | 10% / 0% | 15% / -5% | 20% / -10% |
| Compound Annual Growth Rate (CAGR) | 5% | 4.9% | 4.6% |
4% |