Volatility—It’s a Real Drag

In yesterday’s post, I explained that the noise in returns—in other words, how much they bounce around—is what imposes much of the risk when investing over shorter periods. When you might lose 20 percent or more in a year, any plans that start soon thereafter can be derailed. Volatility (i.e., the noise) is a real drag in that sense.

How volatility affects returns

Volatility is also a real drag in a performance sense. When returns bounce around a lot, the overall value of your portfolio will be less than if you had experienced similar returns without all the noise. The reason is mathematical: losses hurt you more than gains benefit you. This is also true psychologically, but here we are going to focus on the math.

One period at a time, gains and losses are symmetric. If you gain 20 percent on a $1,000 portfolio, you gain $200; likewise, if you lose 20 percent on a $1,000 portfolio, you lose $200. Simple enough. This is not true, though, for a series of returns.

Imagine the same $1,000 portfolio. You gain 20 percent in the first period and then lose 20 percent in the second. What happens here is that you end up with less money than you started with. The same applies if you lose money in the first period and gain money in the second. The volatility itself is what actually damages your portfolio.

Worse, the larger the swing, the greater the loss.

This is the reason large drops in a portfolio’s value require more time to recover, and why noise in portfolio returns can wash out over the long term but be damaging in the short term. It takes longer to make money than it does to lose money.  

How you can mitigate the effects of volatility

Yesterday, we talked about matching your time horizon to your investments so you have time to recover from any noise. There is, of course, another way to approach this problem, which is to eliminate as much of the noise as possible, so your returns are smoother.

This is, in fact, a big part of why diversification works. Diversifying your investments—that is, not putting all your eggs in one basket—is often justified in that it allows you to mitigate the risk of having one investment collapse. That benefit is real. Just as real, though, is the benefit of reducing the volatility, and the associated drag, of the portfolio as a whole. By smoothing out the ride, mathematically you can reduce the negative effects of volatility. There are psychological benefits to doing this as well, but the math works regardless.

This also provides context for why you might want to increase your cash or fixed income allocation when you are approaching your time horizon—or when it looks like trouble is brewing in the markets. Cash has very little to no volatility, and fixed income investments typically have much less volatility than the stock market. By reducing your portfolio’s exposure to the stock market, you might well get lower returns. Depending on your needs, though, that might be a worthwhile trade-off. In fact, this is the standard trade-off in retirement investing: accepting lower returns for lower risk. Now you know why.

Any way you look at it, volatility is not your friend. Strategies to mitigate it are usually worth pursuing, which is why diversification matters. A diversified portfolio is much more likely than a nondiversified one to get you to your goals over time.