Understanding Volatility Drag: The Hidden Impact on Your Investments

We have been conditioned to believe that volatility is just part of investing. Over time it is just unavoidable, and you should learn to expect it and to just roll with it. But there is more to it. Volatility can really drain your portfolio's growth thanks to VOLATILITY DRAG, aka variance drain. It is a term many investors are not familiar with, but they should be. Let's break it down.

What is Volatility Drag?

Imagine you are on a road trip, and your goal is to reach your destination as soon as possible. But along the way, you encounter a few traffic jams,
frequent pit stops, and a detour that actually has you doubling back on a
route you already traveled. All of this slows down your progress, and despite your best efforts, you arrive at your destination late, frustrated, and worn out.

Read more about volatilities here.

In the world of investing, volatility drag is like those detours and roadblocks on your road trip. It refers to the negative impact that market volatility can have on your investment returns over time, slowing you down and diminishing your overall returns.

Volatility drag creates a performance gap. It reduces your actual portfolio growth below its simple average return due to the mathematical effects of volatility over time. The more volatile your portfolio, the wider this performance gap becomes.

Source: Capital Group. Not intended to portray an actual investment.

How Does Volatility Drag Work?

To understand volatility drag, let's consider a simple example.

Imagine you have two investors, Diane and Jack, who each invest $100,000 in the stock market. Diane's investment experiences high volatility, with significant fluctuations in the stock price, while Jack's investment remains relatively stable over the same period.

After 10 years, both Diane and Jack check on their investments to see how they've grown. Here's what they find:

• Diane's Investment: Despite starting with the same amount as Jack,
  Diane's investment has been subject to frequent ups and downs due to volatility in the market. As a result, her investment has experienced
  volatility drag, causing the overall growth to be lower than expected.
  After 10 years, Diane's investment has grown to $150,000.
• Jack's Investment: In contrast, Jack's investment has remained
  relatively stable over the same period, experiencing minimal
  fluctuations in the stock price. As a result, Jack's investment has
  avoided volatility drag and has steadily grown over time. After 10
  years, Jack's investment has grown to $200,000.

In this example, both investors started with the same initial investment
amount, but the impact of volatility drag has resulted in significantly
different outcomes. Despite experiencing the same average annual return, Diane's investment has grown less than Jack's due to the negative effects of market volatility.

Why Does Volatility Drag Matter?

Volatility drag may seem like a minor inconvenience, but its impact can be significant over the long term. Here's why it's important to pay attention to when investing:

• Eroding Returns - Volatility drag can erode your investment returns
  over time, reducing your portfolio's growth and slowing down your
  progress toward your financial goals.
• Increased Risk - Higher volatility in your investment portfolio can
  increase the likelihood of experiencing volatility drag. By
  understanding and managing volatility, you can reduce the risk of
  negative impacts on your investment returns.

• Long-Term Performance - Over longer time horizons, the effects of
  volatility drag become more pronounced. By minimizing volatility
  drag, you can improve the long-term performance of your
  investments and achieve better outcomes. 
• Portfolio Management - Understanding volatility drag is essential for
  effective portfolio management. By diversifying your investments,
  balancing risk and return, and focusing on long-term objectives, you
  can mitigate the impact of volatility drag on your portfolio.
• Investor Behavior - Awareness of volatility drag can help you avoid
  knee-jerk reactions to short-term market fluctuations. By staying
  disciplined and focused on your investment strategy, you can avoid
  making decisions based on emotions and reduce the negative effects of volatility drag.

Volatility drag can erode investment returns over time, highlighting the
importance of managing volatility and staying focused on long-term
investment objectives. By understanding the impact of volatility on
investment performance, you can make more informed decisions and
navigate the complexities of the stock market with confidence.

Find a manager who understands the effects of volatility over time and has the experience and strategies to combat this. Because volatility matters.

Vineyard Global Advisors offers 13 fee-only, actively managed,
including hedged and long-only investment strategies via
separately managed accounts. Contact Us to learn more.