Guide to Volatility Drag for Financial Advisors

Volatility drag quantifies the negative impact that volatility has on the compounded returns of an investment over time. Sophisticated investors and financial professionals may be familiar with this complex concept, but relatively few ordinary investors encounter it. Volatility drag can have a significant effect on the performance of any portfolio, especially over extended periods of time. With that in mind, it’s useful for both investors and financial advisors to understand the basics of volatility drag, how it impacts investments, how to calculate it and strategies to manage it.

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Volatility Drag Explained

Volatility drag occurs when an investment experiences fluctuations in value, leading to a deviation from its expected return. Consider two portfolios with the same starting value and annual average return but different levels of volatility. Over time, the portfolio with higher volatility will be worth less money, despite having the same average return. This phenomenon underscores the impact of volatility on investment performance.

When an investment suffers a decline in value, a subsequent gain of the same magnitude isn’t sufficient to offset the loss. This is because the percentage gain required to recover from a loss is greater than the percentage loss itself. For instance, if a stock drops by 20% from $100 per share to $80 per share, a subsequent 20% increase only brings it to $96 per share. To break even, the stock would need to appreciate by 25%. This asymmetry in the relationship between losses and gains is a core aspect of volatility drag.

Arithmetic vs. Geometric Returns

The gap between an investment’s arithmetic and geometric returns signifies the impact of volatility drag. A widening gap reflects increased volatility within a portfolio.

The arithmetic mean return, or simple average return, calculates the sum of investment returns over a period divided by the number of time periods. It provides a straightforward measure of average return but may not accurately represent the compounded growth rate, especially in volatile investments.

Conversely, the geometric mean return accounts for the compounding effect of returns over time. By multiplying the returns together and taking the nth root, it reflects the compounded growth rate and is less influenced by extreme values.

Financial advisors play a crucial role in helping investors navigate the complexities of volatility drag. By expressing annual returns as the geometric mean return rather than the simple average annual return, advisors provide a more accurate representation of investment performance. Throughout the investing world, the geometric mean return, known as the annualized return, is widely recognized and used by mutual funds and other financial products to express their performance.

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How Volatility Drag Impacts Your Portfolio

SmartAsset: Guide to Volatility Drag for Financial Advisors

Volatility drag matters because most investments have some degree of volatility. When a client experiences years of volatility in the form of above- or below-average returns, the compounding effects result in lower wealth than if they had earned a steady return equal to the arithmetic mean.

For example, say they earn a gain of 60% in the first year and then experience a loss of 40% in the second year. The arithmetic mean, or simple average return, is the sum of 60% and -40%, divided by two, which is the number of years. Here is the calculation:

(First-year return + Second-year return) / Number of years

(60% + -40%) / 2 = 10%

However, the client’s actual cumulative return over the two-year period is negative.

Assume the portfolio begins at $100,000. After gaining 60% in year one, the value rises to $160,000. In year two, a 40% loss reduces the portfolio to $96,000. Compared with the original $100,000, this represents a total loss of 4%.

To calculate the true average annual return, use the geometric mean (compound annual growth rate):

Geometric mean = (Ending value / Beginning value)^{1/number of years} – 1

= (96,000 / 100,000)^0.5 – 1
= -2.02%

Although the arithmetic mean return is 10%, the geometric mean return is about -2%. The difference between these two figures reflects volatility drag: variability in returns reduces the compound growth rate even when the simple average appears attractive.

This effect may seem modest over short periods, but over long horizons it can meaningfully lower ending portfolio values. Strategies that reduce unnecessary volatility can improve long-term compounding outcomes.

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How to Calculate Volatility Drag

Complex statistical formulas exist to get precise figures for volatility drag. However, you can estimate it for your clients by subtracting the geometric mean return from the arithmetic mean return. In the above example, that would look like this:

Volatility drag ≈ (Arithmetic mean return – Geometric mean return)

Volatility drag ≈ 10% – (-2.02%)

Volatility drag ≈ 12.02%

Strategies to Manage Volatility Drag

Though you may be a skilled and experienced advisor, you can’t completely eliminate the effects of volatility drag. However, some methods of minimizing volatility drag over time have proven effective. They include:

Smoothing out volatility with diversification: Diversifying across asset classes with low correlation can help to reduce some of the impacts of volatility drag in client portfolios. For example, balancing stocks with real estate or bonds with commodities and precious metals could help ease the effects of volatility over time.
Rebalancing: Regular rebalancing enables you to ensure that client portfolios maintain the correct asset allocation for their risk tolerance and goals. It can prevent scenarios where a client becomes overweighted in one or two asset classes, which could increase volatility drag if those segments of their portfolio see more frequent up and down price movements.
Investing in assets with lower volatility: Some asset classes and strategies have inherently lower volatility, so it could make sense to talk to your client about making some additions to their portfolios. Typically, that means cash or cash equivalents, such as certificates of deposit (CDs), Treasury bills, and low-volatility ETFs.

Another approach is to limit a client’s exposure to higher-volatility assets. That includes cryptocurrency, leveraged ETFs, penny stocks, and low-liquidity commodities like pork bellies, lumber, or rare minerals and metals.

Model portfolios can prove useful in your efforts to insulate client portfolios from volatility drag. A model portfolio that incorporates assets with low correlation to one another and is periodically rebalanced can help you better mitigate the increased risk of compounded losses that higher volatility may bring.

Bottom Line

Volatility drag is an inherent challenge of investing that erodes returns over time. With any asset that exhibits price volatility, actual returns will lag behind simple average annual returns. While impossible to avoid completely, understanding volatility drag allows you to build portfolios that are optimized for growth over your time frame. That can work in your favor as an advisor for client retention. The more satisfied clients are with their portfolio’s performance, the more likely they are to remain long-term clients.

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