Volatility vs Compound Returns
ETF Prophet | Mar 14, 2012 01:56AM ET
It is clear from looking at the current landscape that volatility is rapidly becoming a key focus for asset management. Witness the birth of “low-volatility” ETFs and the popularity of minimum-variance portfolios borne from empirical studies that demonstrate their superior performance to alternative methodologies.
It seems obvious from the research that volatility is an important factor to consider in portfolio management, but it is neccessary to understand why this is the case. The answer lies in the relationship between the geometric return and the arithmetic return. The geometric return is the return that is achieved through reinvestment or compounding, while the arithmetic return is the simple average of the returns. Often the difference between the two is framed in terms of the impact of positive versus negative returns when you stay invested (compound your wealth).
Most traders understand that large losses hurt their accounts more than a gain of the same magnitude would help their account: for example if you lose 33% of your wealth you need to make 50% to get back to even. Therefore avoiding large losses should be more important than seeking gains to maximize the growth of your account. This insight is part of the rationale behind trend-following and is also the common justification for traders to judiciously use stop losses.
It makes for an excellent example of homespun investment folk wisdom that captures the spirit but fails to capture the science. What is less clear to the vast majority of traders is the deleterious impact of a re-investing wealth in a volatile stream of smaller-sized returns. More formally, Cooper
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