Math Matters Principle 3
Lowering volatility is key to achieving better compound growth. Volatility, how much an investment moves up or down in a period of time, slows down the growth rate of your investments and has a negative impact on compound growth.
Bear markets, market losses of 20% or more, can be rare, catastrophic floods for a portfolio. Everyday volatility can be seen as water damage that slowly erodes away the foundations of your house (i.e., investment returns). This is referred to as volatility drag.
Lowering volatility will help mathematically, and it will help you stick to your financial plan so you can take advantage of compound growth.
The Emotional Side of Volatility
High volatility often causes investors to sell investments due to fear and uncertainty. Getting in and out of the market at the wrong time can negatively affect the long-term success of an investment plan.
How Volatility Impacts Your End Investment
The higher the level of volatility, the more detrimental the impact of volatility drag. The longer the time period, the bigger the negative impact will be.
Let’s take an investment of $100,000 through three different scenarios of volatility and see how it impacts the end result of the investment.
These scenarios detail three possible experiences:
- Up 10% one year, down 5% the next, repeated for ten years
- Up 25% one year, down 20% the next, repeated for ten years
- Up 40% one year, down 35% the next, repeated for ten years
After a decade:
- Scenario A, with most modest gains and losses, performs best and is the only profitable scenario, ending with a 24.6% gain;
- Scenario B breaks even and;
- Scenario C loses money, ending with a -37.6% loss.
Smoothing the Ride for Better Compound Growth
A smoother, less volatile ride, is better for your portfolio results over time, and easier on your emotions along the way.