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Volatility Drag: What is it? What’s it doing to my wealth? And how do I curb it?

Market volatility has soared over the past month of May 2010. Naturally investors are concerned what effect volatility is having on their portfolio.  Your concerns about volatility are warranted. The impact of current volatility levels has reached a point that you need to consider taking action (to your long-term strategy, no panicked, knee jerk reactions please), if you are not already.

Most likely your immediate concern is that volatility suggests future market declines. In this article we wish to talk more broadly about how volatility also diminishes the rate at which your wealth grows over the long-term.

Below we explain the concept of volatility drag, show you the amount of wealth destruction that current volatility is causing and finally make actionable suggestions.

What is volatility drag?

Suppose you have a $100,000 portfolio that experiences a -15% return this month and a 15% rebound next month. The easy math is that your average return is zero. The painful math is that your portfolio went down to $85,000 with the 15% drop and then rebounded to $97,750 with the 15% rebound. Meet Volatility Drag, the $2250 loss you incurred from having your portfolio drop 15% and then rebound 15%, while having an average return of zero.

Or in the opposite simple example, if you gained 100% the first month followed by negative 50% you would have an apparent average gain of 25%, but the wealth compounded is actually zero.  (This is why managers often advertise average annual gains instead of compounded annual returns – the numbers look better). 

Volatility occurs throughout the year, month, day, minute, and even second. All of the fluctuations in price create volatility. These price fluctuations create a continual drag on your portfolio growth: the difference between the average return of your portfolio and the rate at which your wealth compounds. Mathematicians, through the use of stochastic calculus­–the mechanics behind option pricing­– have derived a formula for the drag incurred from volatility. Volatility drag is approximated as half of the volatility squared, and is given in the equation below.

Volatility Drag = .5 * volatility ^ 2 where volatility is measured by the standard deviation of the return sequence.

What is volatility doing to my portfolio?

For simplicity, if you assume that your average return is zero, volatility drag represents the rate at which your wealth dissipates. The example I used above is an intuitively simple way to grasp volatility drag, but the dynamics are more complicated, making the equation above relevant.

We can use this equation to approximate (with a high degree of accuracy) the amount of return reduction occurring in our portfolios due to volatility. The chart below shows the amount of wealth destruction for different levels of volatility.

 

As volatility increases the drag imposed by volatility is accelerating, making it more destructive at higher volatility levels.

The volatility levels of the past month, May 2010, are well above historical averages. The volatility of the all world equity index, ACWI, which is a broad measure of global equities, including the US, developed international and emerging countries has a measured volatility of 37% from May 3 to May 25th 2010. A more typical historical volatility for the ACWI is near 14%.

Using the chart above, we can assess that the annualized return drag associated with a portfolio experiencing a volatility of 37% is 6.8% return annually; while the return drag for a portfolio with 14% volatility only experiences a drag of 1%. Going from 14% to 37% volatility decreases the growth rate of your wealth by 5.8% annually. At a 37% volatility level, if you manage to achieve an average return of 0% you will still lose 6.8% of your wealth per year. Considering that 37% is representative of current volatility levels, it seems prudent to manage this risk and the undesirable consequences.

What can I do about volatility drag?

Given the implications of volatility on the growth of your wealth, you are likely wondering how to mitigate this drag. The simple answer is to avoid high levels of volatility. Portfolio volatility is determined by the volatility of the assets held in the portfolio and their correlation to one another. By measuring volatility and correlation, you can position your portfolio to maintain a desired volatility level.

When you position your portfolio more conservatively, such as including more fixed income than equity, you may give up some additional forecasted performance, because higher risk assets generally have higher expected returns. But you need to determine whether the additional expected return will compensate for the additional drag. In the current environment, you need an additional 5.8% in expected return to justify the increase from 14% volatility to 37% volatility. That’s a lot to expect.



Disclosure: No positions held.