Volatility affects compounding return

By | Investing

(Excerpt from The Iron Law of Volatility Drag by Taylor Pearson)

You have two return streams (a return stream could be a stock, bond, particular trading strategy, etc.)

You know that both will average an annual return of 10%.

There is only one difference between the two return streams:

Return Stream Low Volatility (LowVol) has an annualized volatility of 10%
Return Stream High Volatility (HighVol) has an annualized volatility of 20%
What is the compounded annual growth rate (CAGR) of each?

… the long-term compound growth rates for LowVol will be 9.5% while the long-term compounded return of HighVol will be 8%.

The more volatility in the return stream, the worse the long-term returns. A 10% average annual return stream with 40% volatility will compound at only 2% per year. At 50% volatility, a return stream with a 10% average annual return will actually lose money over time!

This is not very intuitive, but once you work out an example, it makes sense.

As a simple example, let’s say you own a $1 million portfolio. Yay!

In Year 1, it suffers a 50% drawdown. Boo!

However, the next year, the market makes a breathtaking rally of 100%. Amazing!

Over that two-year period, your average annual return is 25%: (A -50% loss in year 1 + 100% Gain in year 2 divided by 2 years = 25% average annual return). However, what is the total portfolio value at the end of the second year?

Well, your $1 million declined to $500,000 in Year 1 (a loss of -50%) and then grew 100% from there to get back to exactly where you started: $1 million, a 0% compounded return.

As the saying goes, your 25% average annual return and two bucks will get you a cup of coffee. In the long run, the compounded return is all that matters. And the volatility of the return stream matters quite a lot to the compounded growth

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