Understanding volatility and compound investment returns

Well, the Gators got slaughtered this weekend and it looks like I’ll lose at least one of my fantasy football matches today. But I do have the Dolphins left tomorrow night against the Pats – there’s still some hope to salvage the weekend. A quick investment blurb for this rainy cold Sunday night in Eastern Tennessee.

In reading investment commentary on the web, much of it truly uninformed, and a lot of the investment product advertising material, I notice that investors confuse two very different type of investment return calculations. When calculating investment returns one can calculate a simple arithmetic mean or the geometric mean (compounded return). The one that truly matters to your investment success, how many dollars you end up with in your account, is the geometric mean. As they say in the investment business, ‘you eat geometric returns’. Are the two really that different? Yes, they can be. Look at the chart below;

Source: Ed Easterling, Cresmont Research

As you can see the more investment returns vary the lower the compounded return. There two basic effects going on here. First, is the law of negative numbers – you need a larger positive return to offset any negative return. If you lose 50% over a period of time, you need to gain 100% to get back to even. Second, the larger the variation of returns around the arithmetic mean the smaller the compounded return. And it matters. In case F, you get 53% less return than case A!

Easterling classifies these two effects as Volatility Gremlins. Negative returns and high volatility are very destructive to long term wealth building and particularly destructive to retirement portfolios where yearly withdrawals are taking place.

My main point is quite simple here – by understanding these volatility gremlins and their effects you can more appreciate investment strategies that reduce volatility and focus more on absolute returns.