Finding your volatility sweet spot

Volatility is more than a temporary decline in value. It can play a critical role in the investment decisions you make, resulting in lower overall returns due to compounding.

Negative performance will hurt your overall expected returns because of the asymmetric performance of compounded returns. Simply put, after a negative return, you have less money invested.

When your investments drop by 1%, you’ll need to earn more than 1% to return to where you started because you’re working with a smaller investment.

Consider the following example of the effects of compounded returns. Imagine earning 10% for three years, then losing 10% for two years. Using quick assumptions, you may anticipate gaining roughly 10% overall. However, a precise calculation based on an initial $100,000 results in only $107,811 at the end of the five years, almost 22% less than anticipated. Even if the poor performance happens early in the investment cycle, the three positive years still don’t push the final value to the expected 10% return.  

The second impact of volatility affects our decision processes due to naturally occurring biases — or shortcuts we rely on — including recency or availability bias, and hindsight bias.

A gambler will typically take a bet when the award is about twice as much as the wager. Similarly, investors are as unhappy about losing $5,000 as they are happy about gaining $10,000. We take losses much harder on the chin, dollar for dollar — a heuristic called loss aversion.

In addition, we tend to overweight current and emotional details in our decisions. Details that are most easily recalled — such as a dramatic or recent loss — will disproportionately contribute to your choice outcomes. For example, you’ll be more likely to contribute to your investment plan if your portfolio performed well last year than if it had lost value. Most people would not consider that, by investing after a loss, you’re buying units of your investment at a lower cost, but instead focus on the overall loss as a sign of heightened risk.

We tend to think more simply and rely on rules of thumb and quick decision processes. If the investment rises, we think in broad categories such as “successful” or “unsuccessful” and are cued to invest more or withdraw based on those conclusions. Of course, you can slow this process down and consider more details, but the natural starting point is the broad experience that influences our choices.

Compounding this effect is the natural disappointment of losing value. It’s common to blame our earlier decision to invest, pointing to poor timing or manufacturing some other regret, in hindsight bias. These feelings of remorse can produce a reluctance to contribute to a well-crafted savings plan after your investment value drops, sometimes making it unpalatable to remain invested at all.

Fortunately, the solution to the mathematical problem of compound negative returns and the key strategy to thwart the biases, heuristics and rules of thumb that interfere with your investment plans are aligned.

If you are easily unnerved by market volatility — marked by a reluctance to continue investing — reduce your exposure to the ups and downs of market oscillations by selecting investments with more predictable patterns. You can also limit volatility by combining asset classes that behave differently during various market conditions to smooth out your return variability. When one asset drops and the other rises, your overall investment steadies.

The net behavioural benefit is the increased likelihood you will stick with your investment contribution strategy by creating a tolerable investment environment.

Limiting exposure to downside risk (volatility) will also produce higher long-term returns because you have less to compensate for when you lose less. Compare an investor whose performance alternates between a positive 12% return and a 12% loss annually for six years, with an investor who oscillates between a 5% return and a 5% loss over the same period. The first investor would have turned his initial $100,000 to $97,030, while the more conservative investor is left with $99,252.

Finding a comfortable level of portfolio volatility will enhance your long-term performance. You’ll know when you have found your volatility “sweet spot” because you will be comfortable contributing to your plan even after an adverse event. When you contribute new funds to the portfolio after a market decline, you buy more units at a lower price. Also, as you reconstitute the portfolio value, you contribute to a better overall return after a decline.

Matching your appetite for variable returns with the level of stability in your portfolio will create a more predictable environment to invest in and improve your overall returns. You’ll limit the impact of negative compound returns and enhance performance by reconstituting your investment after a decline.