The Effects of Risk (Volatility) on Returns

The Effects of Risk (Volatility) on Returns If you could increase your investment success over the long term, would that interest you?

As I progress through this paper, I will provide proof that your investment account is significantly impacted by two related factors: 1) the importance of consistency, and 2) the detriment of losses.

First, let me recap some statistical information I learned after reading a report written by economist, John Mauldin. Mauldin writes "in the 103 years from 1900 through 2002, the annual change for the Dow Jones Industrial Average reflects an average gain of 7.2% per year. During that time, 63% of the years reflect positive returns and 37% were negative. Almost three-quarters of the years exhibited double-digit performance and half exceeded +/- 16%. Most years were far from average and many have been sufficiently dramatic as to drive an investor's pulse into irrational exuberance."

To explain the detriment of losses factor, consider that the simple average of earning 36%, in one year, and losing 30%, the next, calculates to a 3% gain. However, if your investments performed this way over a consecutive two-year period, your account would have lost value.

This is a proven result when great variability exists between positive and negative portfolio returns period to period. How does this happen? If you lose 50% of your money, what do you have to do to break even? You have to double it!

In other words, it takes a 100% gain to offset a 50% loss. But wait! Doesn't the average calculate to a 25% gain? Why is this significant? Though there have been more Dow Jones Industrial Average positive years than negative years in the past century, we need more positive years to offset the detrimental effect of losses. This example also makes evident the importance of avoiding losses altogether.

The importance of consistency factor is a little more challenging to explain.

In finance, investment performance is reported and evaluated in terms of average annual compounded returns ('AACR'). If your investment returns significantly differ from the average each period, your AACR decreases. This is because the AACR reflects the actual result of your investment performance following years of investing.

As an example, if your return over several years calculates to a mean return of +7.2% (mean return refers to the simple or arithmetic average), the highest AACR occurs when all three years deliver exactly +7.2% gains. As variability of returns increase, the AACR decreases. Let me illustrate:

Portfolio A Portfolio B Portfolio C
Year 1 Returns +7.2% +23.2% -7.2%
Year 2 Returns +7.2% +7.2% -22.8%
Year 3 Returns +7.2% -8.8% +51.6%
Simple Average +7.2% +7.2% +7.2%
Compounded Average +7.2% +6.4% +2.8%

Earlier I mentioned that the average return for the stock market was 7.2% annually. However, had you invested $1,000 in 1900, Mauldin cites that your account would have only grown by 4.8% over the subsequent 103 years. Volatility and negative numbers would have consumed one-third of your return.

Now this paper is not meant to discourage investing in the stock market. The stock market has historically provided attractive long-term return rates and has contributed to the wealth of many investors accounts. However, stock market returns are quite volatile and cyclical. How you invest makes a huge difference ' perhaps the most important difference ' as to your long-term returns.

A 1986 study published in the Financial Analysts Journal by Gary Brinson, Randolph Hood & Gilbert Beebower, showed that more than ninety percent of portfolio performance is determined by the asset allocation decision. Asset allocation is the diversification of investments across various asset classes to meet a target level of return at an acceptable level of risk. Given the importance of the asset allocation decision, we consider it to be the foundation of our investment process.

From this author's view, to accomplish diversification, one would seek to be invested in a carefully balanced portfolio of US domestic stocks, options, bonds, real estate investment trusts, and foreign and emerging market equities.

It is no secret that top performing institutional investors, such as the University of Virginia, owe their impressive long-term investment record to asset allocation policies adopted through "bull" and "bear" markets. If your portfolio hasn't grown over the past several years, it may be a clear sign that your holdings are not adequately diversified.