Understanding the Impact of Volatility on your Portfolio

A key investment concept is volatility drag. Volatility drag provides a framework for considering the trade-off between the “cost” and “benefit” of reducing portfolio volatility.

The volatility of your portfolio matters. Reducing portfolio volatility helps deliver higher compound returns over the longer-term. This leads to a greater accumulation of wealth over time.

When introducing volatility reduction strategies into a Portfolio a cost benefit analysis should be undertaken.

The cost of reducing portfolio volatility cannot be considered in isolation.

The importance of volatility and its impact on an investment portfolio is captured in a recent article by Aberdeen Standard Investment (ASI), The long-term benefits of finding the right hedging strategy.

The ASI article is summarised below.  Access to article via LinkedIn is here.

It is widely accept that avoiding large market losses and reducing portfolio volatility is vital in accumulating wealth and reaching your investment objectives, whether that is attaining a desired standard of living in retirement, an ongoing and uninterrupted endowment, or meeting Pension liabilities.

Understanding Volatility Drag

Volatility Drag is a key concept from the paper: if you lose 50% one year, and make 50% the next, your average return may be zero but you’re still down 25%. This is commonly referred to as the “volatility drag.”

The main disconnect some investors have is they look at returns over a discrete period, such as a year, or the simple average return over two years (zero in the case above).

Instead, investors should focus on the realised compound rate.  The compound annualised return in the above example is -13.97% versus simple average return of zero.

ASI make the following point: “The compound (geometric) rate of return will only equal the arithmetic average rate of return if volatility is zero. As soon as you introduce volatility to the return series, the geometric IRR will start falling, relative to the average return.”

This is a key concept to understand.  Volatility reduces compounded returns over time, therefore it impacts on accumulated wealth.  The focus should be on the actual return investors receive, rather than discrete period returns.  Most investment professionals understand this.

Cashflows, into and out of a Portfolio, also impact on actual returns and therefore accumulated wealth.  This is why a 100% equities portfolio is unlikely to be appropriate for the vast majority of investors. The short comings of a high equity allocations is outlined in one of my previous Posts: Could Buffett be wrong?

Thought Experiment

In the article ASI offers a thought experiment to make their point, a choice between two hypothetical investments:

  1. Investment A, has an average annual return of 1% with 5% volatility.
  2. Investment B, has twice the average return (2%) but with four times the volatility (20%).

An investor with a long term horizon might allocate to the higher expected return investment and not worry about the higher levels of volatility.  The view could be taken because you have a longer term investment horizon more risk can be taken to be rewarded with higher returns.

In the article ASI provides simulated track records of the two investments over 50 years (the graph is well worth looking at).

As would be expected, Investment B with the 20% volatility has a much wider range of possible paths than the lower-volatility Investment A.

What is most interesting “despite having double the average annual return, the more volatile strategy generally underperforms over the long term.”

This is evident in the Table below from the ASI article, based on simulated investment returns:

 Average Annual ReturnStandard Deviation of Annual ReturnsAverage total return after 50 yearsAverage realised internal rate of return (IRR)
A1%5%+53%0.88%
B2%20%-3.0%-0.07%

Note, how the IRR is lower than the average annual return e.g. Investment A, IRR is 0.88% versus average annual return of 1.0%.  As noted above, they are only the same if volatility is zero. 

The performance drag, or “cost”, is due to volatility.

Implications and recognising the importance of volatility

The concept of Volatility Drag provides a framework for considering the trade-off between the “cost” and benefit of reducing portfolio volatility.

The ASI article presents this specifically in relation to the benefits of portfolio hedges, as part of a risk mitigation strategy, and their costs with the following points:

  1. The annual cost can be considered in the context of the potential benefits that come from lowering volatility and more effectively compounding returns.
  2. Putting on exposures with flat or even negative expected returns can still increase your total portfolio return over time if they lower your volatility profile sufficiently.
  3. It is meaningless, therefore, to look at the costs of hedges in isolation.

These points are relevant when considering introducing any volatility reduction strategies into an Investment Portfolio i.e. not just in relation to tail risk hedging. A cost benefit analysis should be undertaken, investment costs cannot be considered in isolation.

As ASI note, investors need to consider the overall portfolio impact of introducing new investment strategies, specifically the impact on the downside volatility of a portfolio is critical.

There are a number of ways of reducing portfolios volatility as outlined below, including the risk mitigation strategies of the ASI article.

Modern Portfolios

The key point is that the volatility of your portfolio matters.  Reducing portfolio volatility helps in delivering better compound returns over the longer-term.

Therefore, exploring ways to reduce portfolio volatility is important.

ASI outline the expectation that volatility is likely to pick up in the years ahead, “especially considering the current extreme settings for fiscal and monetary policy combined with rising geopolitical tensions.”

They also make the following pertinent comment, “Uncertainty and volatility aren’t signals for investors to exit the market, but while they persist, we expect investors will benefit over the medium term from having strategies available to them that can help manage downside volatility.”

ASI also note that investors have access to a wide range of tools and strategies to manage volatility.  This is particularly relevant in relation to the risk mitigation hedging strategies that manage downside volatility and are the focus of the ASI article.

Therefore, a modern day portfolio will implement several strategies and approaches to reduce portfolio volatility, primarily as a means to generate higher compound returns over time. This is evident when looking at industry leading sovereign wealth funds, pension funds, superannuation funds, endowments, and foundations around the world.

Strategies and Approaches to reducing Portfolio Volatility

There are a number of strategies and approaches to reducing portfolio volatility, Kiwi Investor Blog has recently covered the following:

  1. Real Assets offer real diversification: this Post outlines the investment risk and return characteristics of the different types of Real Assets and the diversification benefits they can bring to a Portfolio under different economic scenarios, e.g. inflation, stagflation.  Thus reducing portfolio volatility and enhancing long-term accumulated returns.
  2. Sharemarket Crashes – what works best in minimising loses, market timing or diversification: This Post outlines the rationale for broad portfolio diversification to manage sharp sharemarket declines rather than trying to time markets.  The Post presents the reasoning and portfolio benefits of investing into Alternative Assets.
  3. Is it an outdated Investment Strategy? If so, what should you do? Tail Risk Hedging?: This Post outlines the case for Tail Risk Hedging.  A potential strategy is to maintain a higher allocation to equities and to protect the risk of large losses through implementing a tail risk hedge.
  4. Protecting your portfolio from different market environments – including tail risk hedging debate: This Post compares the approach of broad portfolio diversification and tail risk hedging, highlighting that not one strategy can be effective in all market environments.  Therefore, investors should diversify their diversifiers.
  5. What do investors need in the current environment? – Rethink the ‘40’ in the 60/40 Portfolios?: With extremely low interest rates and the likelihood fixed income will not provide the level of portfolio diversification as experienced historically this Post concludes Investors will need to rethink their fixed income allocations and to think more broadly in diversifying their investment portfolio.

Happy investing.

Please see my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

Image from CFA Institute Blog: When does Volatility Equal Risk?

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