Volatility drag quantifies the negative impact that volatility has on the compounded returns of an investment over time. Sophisticated investors and financial professionals may be familiar with this complex concept, but relatively few ordinary investors encounter it. Volatility drag have a significant effect on the performance of any portfolio, especially 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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Volatility Drag Explained
Volatility drag occurs when an investment experiences fluctuations in value, leading to a deviation from its expected return. Consider two portfolios with the same starting value and annual average return but different levels of volatility. Over time, the portfolio with higher volatility will be worth less money, despite having the same average return. This phenomenon underscores the impact of volatility on investment performance.
When an investment suffers a decline in value, a subsequent gain of the same magnitude isn’t sufficient to offset the loss. This is because the percentage gain required to recover from a loss is greater than the percentage loss itself. For instance, if a stock drops by 20% from $100 per share to $80 per share, a subsequent 20% increase only brings it to $96 per share. To break even, the stock would need to appreciate by 25%. This asymmetry in the relationship between losses and gains is a core aspect of volatility drag.
Arithmetic vs. Geometric Returns
The gap between an investment’s arithmetic and geometric returns signifies the impact of volatility drag.
The arithmetic mean return, or simple average return, calculates the sum of investment returns over a period divided by the number of time periods. It provides a straightforward measure of average return but may not accurately represent the compounded growth rate, especially in volatile investments. Conversely, the geometric mean return accounts for the compounding effect of returns over time. By multiplying the returns together and taking the nth root, it reflects the compounded growth rate and is less influenced by extreme values or outliers.
Financial advisors play a crucial role in helping investors navigate the complexities of volatility drag. By expressing annual returns as the geometric mean return rather than the simple average annual return, advisors provide a more accurate representation of investment performance. Throughout the investing world, the geometric mean return, known as the annualized return, is widely recognized and used by mutual funds and other financial products to express their performance.
How Volatility Drag Impacts Your Portfolio
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%
But 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:
- Smooth out volatility with diversification. Diversify across asset classes with low correlation.
- Rebalance your portfolio. Rebalancing forces you to buy low and sell high.
- Invest in assets with lower volatility. Some asset classes and strategies have inherently lower volatility.
Bottom Line
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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