The week of August 8, 2011, was one for the record books. Never before had the Dow Jones Industrial Average gone through four consecutive days when it closed more than 400 points up or down. In fact, in the course of those four days, the market zigzagged a total of more than 2,000 points, or nearly 19% of its value at the close on Friday, August 5.
After all the gyrations, the Dow was down only 175 points - 1.5% - for the full week. Still, the cluster of swings was an eerie reminder of how much the market can fluctuate on a short-term basis. Those swings underscored the real - though not widely appreciated - problem with volatility: even when stock prices recover, volatility is a drag on returns.
Illustrations are in order. First, the table below compares the returns over three years in two hypothetical portfolios, each of which invests $10,000.* The table summarizes the returns in three ways: the arithmetic average of their rates of return, the volatility of their returns (as measured by standard deviation), and their compound growth rate per year.
While both portfolios have the same average rate of return when computed arithmetically (i.e., the sum of the percentage returns divided by three), they have quite different final balances. The reason is that Portfolio A's returns were much more volatile than Portfolio B's. As a result, there is also a significant difference in their compound rates of return.
The explanation is that big losses take away from the power of compounding. Whenever a portfolio loses money in a given year, it takes a bigger percentage gain to break even. That also explains why an aggressive portfolio that gets much better returns than a more conservative portfolio in years when the stock market is strong can underperform a slower-but-steadier strategy.
Here's a more real-world comparison.* Again, each of these hypothetical investments starts with $10,000, but this time, actual returns are used for five years based on returns of the Standard & Poor's 500 Index and of long-term government bonds (Source: Ibbotson Stocks, Bonds, Bills, and Inflation Classic Yearbook, 2011). Portfolio A invests only in stocks, while Portfolio B puts 60% in stocks and 40% in bonds.
Historically, over the long term, total bond returns have been lower than returns for stocks, with the tradeoff that bond returns tend to be more consistent year-to-year than stock returns. The difference shows up quite plainly in the above example: a 3% advantage in compound annual return is worth more than $1,700 over the five-year period examined for the slower-but-steadier strategy.
Helping you build portfolios that minimize the damage volatility can cause - while meeting your long-term need for returns - is an important part of your investment plan for the long term. Please call if you'd like to discuss your portfolio in more detail.
* These examples are provided for illustrative purposes only and are not intended to project the performance of a specific investment.