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Why Volatility Matters

When managing portfolios for clients we focus on diversification to help reduce fluctuation in returns, or volatility. Less volatility can improve the compound return of a portfolio over time—helping you better meet long-term goals like funding your retirement or accumulating wealth.

Consider two assets with the same average return over a two year period. One asset is a stable investment that earns 5% each year. The second is a risky investment that earns 50% in the first year but loses 40% the following year. Although each asset has the same average return over the two year period, the growth of a $1000 investment in each asset is very different. The investor in the stable asset will earn a little over $100 while the investor in the risky asset will lose $100.

Volatility Examples for Two Portfolios
Type of Investment Initial Investment Year 1 Return Year 2 Return Average Return Compound Return Value at End of Year 2
Stable  $1,000.00 5.0% 5.0% 5.0% 10.3% $1,102.50
 Risky $1,000.00 50.0% -40.0% 5.0% -10.0% $900.00

 

Differences in compound return, or wealth creation, are caused by the volatility of each investment’s returns. The higher the volatility, the lower the compound return will be relative to its average return. In fact, compound returns are maximized when the return each period is consistent.

Managing volatility is particularly crucial during a market downturn. After experiencing a loss, a portfolio must earn an even higher return in future periods to fully recover to its previous level. Accepting some volatility may be necessary to achieve attractive returns. Investments with higher uncertainty often have higher long-term growth potential. Nonetheless, we find it important to appropriately balance risk and potential return, focus on long-term success instead of short-term performance, and take full advantage of diversification. Although diversification cannot protect against loss, it can help reduce portfolio volatility and may lead to higher compound growth.

We believe it is important to understand the degree of volatility in any investment, along with its potential impact on your overall investment strategy. As always, please contact your financial advisor with questions regarding your portfolio.

 

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