We’ve all heard that price volatility is bad for investments. However, most investors couldn’t give a great explanation as to how or why. Many would say that volatility is bad because it feels bad. After all, investors can lose money in volatile markets. It’s mentally and emotionally painful to see an investment drop in value. Without question, that is one reason why volatility is harmful to an investment. However, it isn’t the most important reason.
Let’s talk about volatility.
Investopedia.com defines volatility as, “a statistical measure of the dispersion of returns for a given security or market index.” Great, not sure that definition helps us too much. How about we talk about volatility in plain English.
Generally, when we talk about volatility, we’re speaking about large swings in the price or value of an investment. That investment can be a stock, a property, a commodity, a portfolio, or any other asset that has a value attached to it. For example, when the stock market unexpectedly drops or gains over a short period of time, it’s considered a volatile market. Investors have seen quite a bit of volatility in the stock market over the last two decades.
Most investors understand that, in general, the more volatile an investment, the riskier. But let’s be clear, no one minds volatility when prices go up. The volatility that investors are trying to avoid is any large, unexpected drop in value.
There are three main ways that volatility can harm an investment:
First, and most obvious, a volatile investment can quickly and unexpectedly lose value. It can be mentally and emotionally painful to watch an investment drop in value in a volatile market. Most investors have felt that fear at some point in time. The fear and uncertainty caused by volatility can lead to irrational and (usually) bad investment decision making. For this reason alone, most investors are best served by avoiding volatile investments.
Second, it is difficult for a highly-volatile investment to recover its value after a significant drop. Example: If an investment drops by 50%, it will not recover its value with a subsequent 50% increase. In this instance, the investment will actually need a 100% increase just to recover from the loss. It can be very challenging for an investment to recover after experiencing downside volatility.
Last, volatility can disrupt the ability of an investment to compound returns. The power of compounding returns is one of THE most important elements needed to build wealth over time. Volatility – particularly downside volatility – is the biggest enemy to taking advantage of the power of compounding returns.
Let’s discuss compounding returns.
Investopedia.com defines compounding returns as “the rate of return, usually expressed as a percentage, that represents the cumulative effect that a series of gains or losses has on an original amount of capital over a period of time.” Again, not super helpful. Let’s use an example to help understand compounding returns in layman’s terms.
If an investment returned 10% each year for two years, at the end of those two years the investment would have actually grown cumulatively by 21%, not 20%. Why is that? Because in year 2, the investment returned 10% on top of the previous year’s gain of 10%. THAT is the power of compounding returns. I realize this may not seem like a big difference over one year. However, this dynamic, carried forward over years and decades can have a tremendous positive effect on the value of an investment. The power of compounding returns is what gives an investment the ability to achieve tremendous cumulative returns over a lifetime.
Volatility in an investment disrupts the power of compounding returns. An investment that achieves consistent returns with low volatility will always grow larger over time than one with a higher volatility, even if that investment has a similar return profile.
The chart below shows how two hypothetical $1,000,000 portfolios, one high and one low volatility, perform over a 20-year period. Both the portfolios have the same average annual return of 9.6%. However, the low volatility outperforms the high volatility significantly, in fact by over 180% or $1.8 million. That’s some real cash.
Now that you know the three ways that volatility can harm an investment, what can you do about it?
Finding an investment that exhibits stable, consistent annual returns along with low volatility is the answer. An optimal investment will have a value that grows in a consistent and predictable fashion, taking advantage of the power of compounding returns. In addition, it will also exhibit low volatility, thus avoiding large drops in value which it would need to recover from.
When searching for investments, most investors understandably focus on potential returns. However, paying close attention to the underlying potential volatility of the investment is equally important. Investments that return a stable, consistent and non-volatile return stream will always be superior to those that exhibit large swings in value over time.
At Aloha Capital, investments that offer stable, consistent, and non-volatile returns is exactly what we do.