When thinking about their portfolios, many investors focus on long-term outcomes such as total returns or income. If they think about volatility at all, they usually equate it with risk and write it off as unavoidable—the emotional price paid for investing.
However, volatility should not be ignored. It’s a profound force that can have a dramatic effect on the performance of a portfolio over time.1
What is volatility?
In its simplest form, market volatility is a measure of how much stock prices rise and fall from day-to-day.2 We usually define stock volatility in terms of standard deviation, which measures how much a price varies around its average.
The chart below shows the weekly returns of two hypothetical stocks, both of which start trading in week 1 at $10 and end week 10 at $11 (see table). Both offered a simple return of 10 percent, but the standard deviation of the returns for Stock A was 4.9 percent, while the standard deviation of returns for Stock B was 50 percent. In any given week, Stock B’s return could have been 50 percent higher or lower than its average weekly return, while stock A hardly moved from its average.
From your perspective, this illustration may suggest that volatility doesn’t matter because both stocks ended up in the same place ($11) and offered the same simple return (10 percent). But that’s not quite correct.
Volatility and investing
Volatility has the potential to erode portfolio returns through volatility drag. Let’s look at some examples.
The difference between simple average returns (which are commonly reported by mutual fund managers) and true returns is known as volatility drag.
The chart and table below illustrate the impact volatility drag can have on a portfolio.3 There are three scenarios here, all of which experience regular ups and downs—for example, in Scenario A, the portfolio rises 10 percent in year 1, then falls 5 percent in year 2, rising 10 percent again in year 3 and so on.
In all three scenarios, the simple average return over 20 years is 2.5 percent. However, the magnitude of volatility is different, and this has a major impact on compound annual growth rate (CAGR), which is the true measure of portfolio performance.4
In the low-volatility scenario, investors would experience a (CAGR) of 2.23 percent and see their money increase 70 percent over 20 years, while in the high-volatility scenario, investors would have lost 67.8 percent of their money and experienced a CAGR of -4.61 percent.
First, it’s better to have modest growth with modest volatility than it is to have huge growth with major volatility. Second, managing volatility at the portfolio level can be a major driver of long-term performance.
Including an allocation to real estate alternatives that have a low correlation to traditional asset classes may help diversify your portfolio and lower overall volatility. In the long-term, this may help you avoid both anxiety and investment underperformance.