Volatility…What A Drag!

You may not have heard of ‘Volatility Drag’ before but you may already have an intuitive idea of what it is.

What Is Volatility Drag?

The concept is probably best explained with a simple example.  Let’s suppose you have $100 invested and experience a 33% loss in the first year, bringing your invested assets down to $67.  Now to return back to $100 in the next year, you need almost a 50% gain (not a 33% gain) to get back to your original $100.  So even if you lost 33% in the first year and gained 50% the next year, your average return over 2 years is (-33+50)/2 = 8.5%.  But your compound return is 0%!  The greater the variance in returns, the more exaggerated the effect.

Volatility Drag is the difference between the average return and the compound return.  In the above example, the volatility drag would be 8.5% (8.5% – 0%).

So, if you had to choose between 2 investments that could both hypothetically return 10% on average, you would want to choose the one with smaller price fluctuations to minimize the volatility drag.

If you are in the retirement stage of your life and are withdrawing funds from your portfolio, the effect from volatility drag can be detrimental especially after a downturn in your portfolio  since you will have a smaller portfolio to participate in the upswing if and when it happens after you have withdrawn funds from portfolio (but that’s a topic for another day).

So What?

Standard and Poor’s research article ‘The Low Volatility Effect: A Comprehensive Look’ references empirical evidence illustrating that low volatility investing outperforms the broad market on a risk-adjusted basis over the long term.  This effect exists on the global market according to this research, not just the US market.

The conclusions from the research are:
a) Low volatility strategies produce better risk-adjusted returns over the long run
b) In up-trending markets, the low volatility strategies will not perform as well compared to the market
c) The effectiveness of the low volatility applies on a global scale

The problems volatility drag creates combined with the research that says low volatility investing has some merit should make investors consider adding low volatility strategies for at least a part of their portfolio.  It seems that trying to reduce the magnitude of losses might seem more important than trying to maximize the magnitude of gains.

Reducing Volatility

One way to lower the volatility of your portfolio is to simply use low volatility ETFs.  iShares, PowerShares, and BMO ETFs have all introduced low volatility equity ETFs for those who are interested in adding a less volatile equity component to their portfolios.

In the Sample ETF Portfolios section of this blog, I have created a sample low volatility equity portfolio.  iShares has ETFs that covers the major global markets, however, in the sample portfolios, I choose to use ETFs from BMO and PowerShares as they seemed to have a more defensive tilt at the time of this writing.  In addition, BMO’s low volatility ETF has a lower allocation to financials.  Since most Canadians invested in the Canadian markets already will have a large allocation to the financial sector, using this ETF provides some diversification as compared to using iShares’ low volatility ETF for the Canadian market.

Conclusion

When evaluating potential investments, it’s important to consider potential compound returns not just potential average returns.  Adding low volatility strategies can provide better returns on a risk adjusted basis.  Keep in mind however the nominal returns may not be high enough to meet your investment objectives.

Disclaimer
The contents in this post and site are not to be taken as advice. Please consult your qualified advisor before taking action.

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