This is the editorial of our monthly Quant Value Investment Newsletter published on 1 October 2024. Sign up here to get it in your inbox the first Tuesday of every month.
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This month you can read why keeping the volatility of your returns low is the key to growing your wealth.
Why Low Volatility Gives You Higher Returns
Imagine you invest $10,000 in the stock market.
- In one scenario your investment grows steadily at 5% per year.
- In another it grows by 50% one year and drops 33% the next.
After two years, which scenario do you think would leave you better off? It might seem like the bigger gains in the second scenario would give you more money ($1,005.00), but steady growth ($1,102.50) performed better and is much more powerful over time.
That’s because large swings in value, or volatility, hurt your returns more than you think.
This month I want to share something with you that took me a while to fully understand. Keeping the volatility of your investment returns low is the key to growing your wealth. In other words, why reducing roller-coaster returns in your portfolio gives you higher results in the long run.
What is Volatility and Why Does It Matter?
Volatility measures how much an investment’s value fluctuates over time. Think of it like the waves in the ocean.
When an investment is highly volatile, it makes frequent large up and down moves, big waves. This might sound exciting, but it makes it harder for your money to grow steadily.
Let’s take a simple example. Imagine two investments:
• One grows 10% every year, and
• The other grows 30% one year but drops 10% the next.
If you invested $1,000, after two years, the first investment would grow like this:
Year 1: $1,000 x 1.10 = $1,100
Year 2: $1,100 x 1.10 = $1,210
The second investment, even though it has a big 30% gain, would look like this:
Year 1: $1,000 x 1.30 = $1,300
Year 2: $1,300 x 0.90 = $1,170
In the second scenario, the average return over two years is 10% ((30% - 10%) / 2), but the result is worse than the steady 10% return. This is the negative effect of volatility in action: large swings drag your returns down.
Key Point: Even with the same average return, volatility reduces your overall growth. This makes steady returns more beneficial.
The Volatility Drag: How It Lowers Your Returns
One of the hidden dangers of volatility is something called “volatility drag.” It means that the more your investment bounces up and down, the lower your long-term growth will be, even if the average return looks good.
Let’s look at another example to understand how this works.
Suppose you have an investment that gains 50% in one year but loses 33% the next. You might think this evens out, but it doesn’t. If you start with $1,000, the numbers look like this:
Year 1: $1,000 x 1.50 = $1,500
Year 2: $1,500 x 0.67 = $1,005
Even though the average return over two years is 8.5% ((50% - 33%) / 2), your actual growth is only 0.5%.
This happens because losses have a bigger impact than gains of the same size. It takes more effort to recover from a loss than it does to benefit from a gain. That’s why volatile investments often underperform steady ones, even when their average returns are the same.
Why Low Volatility Equals Steadier Growth
Low volatility means more stable, consistent returns over time, which allows your money to grow steadily.
Let’s compare two investments again: one with consistent returns and one with volatile returns. Say you invest $10,000 in two portfolios. The first portfolio grows by 5% every year, while the second grows by 30% in the first year and then loses 20% in the second.
After two years, here’s how each investment would perform:
Steady portfolio (5% per year):
Year 1: $10,000 x 1.05 = $10,500
Year 2: $10,500 x 1.05 = $11,025
Volatile portfolio (30% in Year 1, -20% in Year 2):
Year 1: $10,000 x 1.30 = $13,000
Year 2: $13,000 x 0.80 = $10,400
Even though the average return in both cases is 5%, the steady portfolio leaves you with more money because the volatile portfolio’s losses drag your return down. This is why low volatility equals better growth in the long run. When returns are more consistent, your investments compound more effectively, leading to greater wealth over time.
The Importance of Diversification and Rebalancing
One of the best ways to reduce volatility in your portfolio is through diversification. This means spreading your investments across different assets, like stocks, bonds, and cash, to lower the overall risk.
For example, if you put all your money in one stock, a big drop in that stock could hurt your entire portfolio. But if you invest in a mix of different stocks and bonds, the risk is spread out. When one investment goes down, another might go up, helping to stabilise your returns.
The second way to reduce volatility is through rebalancing which works like this. Suppose you start with a portfolio that is 50% stocks and 50% bonds. After one year, stocks perform well and grow to 60% of your portfolio, while bonds drop to 40%. To maintain your desired level of risk, you would rebalance by selling some stocks and buying more bonds, bringing your portfolio back to 50/50.
Rebalancing ensures that you “buy low and sell high” without making emotional decisions. It also helps keep your risk in check and your returns more stable.
The Long-Term Impact on Your Wealth
The real benefit of keeping volatility low is the long-term impact on your wealth. When your investments grow steadily, they compound more effectively over time.
And it is compounding is what allows your money to grow exponentially. This is because you earn returns not only on your original investment but also on the returns you’ve already made.
Volatility interrupts this process because large drops take longer to recover from, slowing down your progress.
Conclusion
Reducing the volatility of your investments is crucial for long-term success. Even if the average return looks good, large swings in value can drag your returns down and slow your progress.
By focusing on low-volatility investments, diversifying your portfolio, and rebalancing regularly, you can protect yourself from big losses and enjoy the benefits of steady, reliable growth.
Remember, investing isn’t about chasing the biggest returns. It’s about growing your money consistently over time while avoiding the damaging effects of volatility. By keeping your returns steady, you’ll build wealth more effectively and with much less stress.
How The Newsletter Keeps Volatility Low
In the newsletter we keep the volatility of your returns low by:
- Not buying when markets are falling
- Following a strict stop loss strategy
- Keeping individual investments small. Only 2% of your portfolio in each idea.
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