There has been a lot of talk about expected market volatility in 2015 – see for yourself (VIX Index). In fact CNN posted this yesterday. If market were to correct what will happen to your portfolio returns? And exactly how does volatility eats away at your prior returns?
For starters, nothing destroys your returns in the stock market CONSTANTLY like volatility. In this post we will delve into the concept of volatility drag, its effect on your returns and what can be done about it.
What is it?
Imagine if you had a $ 100,000 portfolio that gained 100% in year 1 (hooray!) but then suffered a 50% loss the year after. The average apparently is 25% (wow! World beater!) but your compounded wealth is zero (why you ask? You went up to 200K after year 1 only to fall on your face back to 100K in suffering that 50% loss). This is also the very reason money managers advertise average annual gains – they look spectacular.
Here is the real kicker though – volatility happens every moment down to a second. This drags downs your portfolio constantly due to price fluctuations in the market. Can’t get out of this vortex!
Mathematicians have defined it numerically as Volatility Drag (Reduction in return) = 0.5*(Volatility)2
(See THIS for full details)
So for example if annual market volatility is 20% (it’s above 20 TODAY!), then per formula the drag is 2% (see chart below)
With all the talk for volatility in our “mature” market, investors should pay attention and include volatility drag in their investment return equation. Also, extra volatility has exponential drag – a 20% volatility might be just 2% drag, but 40% is an 8% drag on your returns!
What to do about it?
How does one mitigate the said drag. Simple answer would be to avoid highly volatile assets. The easiest way practically to achieve is including fixed income assets with low volatility rather than equities. While one does not make 30% returns (2013 anyone?), you also are more sure of your returns. In this case, Peer to Peer lending – such as investing in Lending Club notes, or Prosper – or Peer to Business lending like REAMERGE offer stable returns under fixed income asset class and classically higher than your average corporate bonds.
In fact, lets do a head to head comparison with S&P500 – if you were to invest in Reamerge way back in 2007 and reinvest your returns (CAGR) then vs S&P 500 your year after year returns would be (assuming 10% returns*):
Not too shabby eh?* This is an example showing no volatility vs a volatile stock market (that rallied aggressively in 2011-2013, still hasn’t caught up to stability!)
What do you think? Please comment or should you have further questions, please email us at firstname.lastname@example.org
*This is an example. Past performance is not indicative of future performance. Any financial projections or returns shown on the site are examples only and Investors should conduct their own due diligence and not rely on the financial assumptions or estimates that are displayed here. This post does not constitute an offer by REAMERGE, LLC. to sell, solicit or make an offer to buy any investment interest or securities. REAMERGE does not give or offer any business advice, investment advice, tax or legal advice to anyone using this blog or on website.