Up and down math. Volatility over the past couple of months has thrown everyone for a loop. It’s part of the investing experience, though admittedly not the fun part. You have become wise and patient investors focused on the long-term and leery of near-term noise. Every investor’s portfolio is different, addressing different objectives and risk tolerance.
A staple of wealth-based portfolio design is risk mitigation and requires an understanding of sequential returns. I know… who wants to hear about math?!? Don’t worry. There is no hard math here; just food for thought about how returns ultimately affect portfolio values.
Returns are a peculiar thing. Grade school math 1+1=2 math need not apply. Portfolio architects need to be aware, if not well educated, how serial returns (returns from one period to the next) ultimately affect portfolio values. It seems logical that simply summing returns is all that is needed. However, a simple summation would ignore compounding effects, such as how returns from one period influence the next period.
Let’s review an example that oscillates between a positive 10% return and a negative 10% return. Starting with $1000, logic would dictate that summing 10 years of such returns would end up with the same $1000. Logic would suggest a gain of $100 in the positive years and a decline of $100 in the negative years. The reality is quite different. After 10 years, the investor would end up with $951! In such a scenario, the negative 10% has a more deleterious impact than the beneficial impact of the positive 10%. It seems odd, but it’s true.
What does this have to do with investing? In short, when developing a portfolio for the long-term, a portfolio architect needs to be aware of short-term return compounding effects. More importantly, the farther the decline, the more that is required to breakeven. Should a portfolio decline 10%, a subsequent 11% would be required to breakeven. Throttle that up to a -30% decline and a 43% return would be needed to breakeven. A 50% decline would require a 100% return to breakeven. You get the point. So, portfolio architects should not just focus on average returns but also on the range of possible returns, specifically on the ruinous deep declines impacting the long-term.
Mastering financial markets statistics and grasping investment math provides the backdrop to portfolio design. The wild card is unpredictable volatility timing. Therein lies the quandy. Since volatility timing is unknown, building shock absorbers into the portfolio before the potholes occur should translate to a smoother ride and mitigate downside impacts when they occur.
Recent Comments