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Guide to Volatility Drag for Financial Advisors

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A financial advisor looking at volatility drag between two similar investments.

Volatility drag is one of the risks in investing. Volatility drag is a complex concept familiar to many sophisticated investors and financial professionals while relatively few ordinary investors have ever heard of it. It can have a significant effect on the performance of any portfolio, however, particularly over extended periods of time. With that in mind, it’s useful for both investors and financial advisors to understand the basics of volatility drag, how it impacts investments, how to calculate it and strategies to manage it.

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What Is Volatility Drag?

To understand volatility, and drag, consider two portfolios containing different investments but with the same starting value and the same annual average return. Although they have the same average return, over time the portfolio that experiences higher volatility will be worth less money. This is volatility drag.

The effect is driven by volatility, which is the amount of fluctuation in the price of a security or other asset over time. Volatility causes actual performance to be different from the simple or arithmetic average return, which is the sum of investment returns over a period divided by the number of time periods.

The geometric mean return is another growth rate that when applied to the starting value over time produces the actual ending value. This gap between arithmetic and geometric returns is the volatility drag. Volatility drag is also known as variance drain.

In simple terms, volatility drag reduces your actual portfolio growth below its simple average return due to the mathematical effects of volatility over time. The more volatile your portfolio, the wider this performance gap becomes.

Fortunately, financial advisors routinely express annual returns as the geometric mean return rather than the simple average annual return. Throughout the investing world, geometric mean return is known as the annualized return and mutual funds and other financial products state returns as annualized returns instead of the typically higher average returns.

How Volatility Drag Impacts Your Portfolio

SmartAsset: Guide to Volatility Drag for Financial Advisors

Volatility drag matters because most investments have some degree of volatility. When you experience years of volatility in the form of above or below-average returns, the compounding effects result in lower wealth than if you had earned a steady return equal to the arithmetic mean.

For example, say you earn a gain of 60% in the first year and then experience a loss of 40% in the second year. Your arithmetic mean or simple average return is the difference between 60% and 40% or 20%, divided by two, which is the number of years. Here is the calculation:

Average return = (First-year return – Second-year return) / Number of years

Average return = 60% – 40% / 2

Average return = 20% / 2

Average return = 10%

In fact, however, your actual return is -4% over the two years. The 14% performance gap between the simple average return and your actual return is a volatility drag in action. Here’s how to figure actual return and reveal the volatility gap:

Your portfolio value at the beginning of the first year is $100,000. After gaining 60%, the portfolio value at the end of the first year is $160,000.

In the second year, the starting value is $160,000. After a 40% loss, by the end of the second year, the value drops to $96,000 for a 4% overall loss.

To calculate the actual average annual return, first figure the total return over two years by subtracting the original value from the final value and dividing by the original value. Here’s the calculation:

Total return over 2 years = (Final value – Original value) / Original value

Total return over 2 years = ($96,000 – $100,000) / $100,000

Total return over 2 years = -$4,000/$100,000

Total return over 2 years = -4%

If you divide the total return by the number of years, you get an actual average annual return, like this:

Actual average annual return = Total return / Number of years

Actual average annual return = -4% / 2

Actual average annual return = -2%

This effect can be small in the short run but adds up over decades. Minimizing volatility can help maximize your ending portfolio value.

How to Calculate Volatility Drag

Complex statistical formulas exist to get precise figures for volatility drag. However, you can estimate it by subtracting the geometric mean return from the arithmetic mean return. In the above example, that would look like this:

Volatility drag ≈ (Arithmetic mean return – Geometric mean return)

Volatility drag ≈ 10% – (-2%)

Volatility drag ≈ 12%

Strategies to Manage Volatility Drag

You can’t completely eliminate the effects of volatility drag. However, some methods of minimizing volatility drag over time have proven effective. They include:

1. Diversify across asset classes with low correlation. This smooths out volatility.

2. Rebalance your portfolio. Rebalancing forces you to buy low and sell high.

3. Invest in lower volatility assets – Some asset classes and strategies have inherently lower volatility.

Bottom Line

SmartAsset: Guide to Volatility Drag for Financial Advisors

Volatility drag is an inherent challenge of investing that erodes returns over time. With any asset that exhibits price volatility, actual returns will lag behind simple average annual returns. While impossible to avoid completely, understanding volatility drag allows you to build portfolios that are optimized for growth over your time frame.

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