Understanding the Impact of Average Rate of Return and Volatility on Your Investments

Investors often hear about the importance of the average rate of return when evaluating their investments. However, it's equally important to understand how volatility—or the degree of variation in investment returns—can significantly impact the long-term growth of your portfolio. This article will delve into why less volatility can produce higher dollar amounts in your account over time, even if the average rate of return remains the same.

The Average Rate of Return

The average rate of return is a simple mathematical average of the returns that an investment generates over a specific period. For example, if you have an investment that yields 50%, -26%, and 12% over three years, the average rate of return would be (50% - 26% + 12%) / 3 = 12%.

While the average rate of return provides a snapshot of past performance, it doesn't tell the whole story. To fully understand the potential growth of your investment, you need to consider the impact of volatility.

Understanding Volatility

Volatility refers to the fluctuations in the value of an investment. High volatility means an investment's value can change dramatically in a short period, while low volatility indicates more stable performance.

Here's an example to illustrate the impact of volatility using the provided data:

The Volatility Effect

To understand the effect of volatility on investment growth, consider three investors, Alice, Bob, and Carol, who start with $1,000 and invest in Investment A, Investment B, and Investment A+B, respectively.

Investment A:

Despite having similar average annual returns (12% for Investment A, 10% for Investment B, and 11% for Investment A+B), the impact of the negative return in the second year for Investment A significantly reduces Alice's total gain, leaving her with $1,110 at the end of Year 2. Bob, with Investment B, ends up with $1,170, while Carol, with the diversified Investment A+B, ends up with $1,224.

Why Less Volatility Matters

Compounding Effect: With less volatility, each year's returns build on a higher base amount, leading to greater compounding benefits over time.
Reduction of Negative Impact: Avoiding or minimizing negative returns helps maintain the growth trajectory of an investment. Losses require higher subsequent gains to recover, which is why smoother returns often lead to better long-term outcomes.
Psychological Comfort: Investors are more likely to stick with an investment that shows steady growth, reducing the likelihood of panic selling during downturns.

Practical Implications

When designing an investment strategy, it's crucial to not only seek high returns but also to consider the volatility of your investments. Diversifying your portfolio, incorporating less volatile assets, and having a long-term perspective can help mitigate the impact of volatility.

Conclusion

While the average rate of return is a vital metric, understanding and managing volatility can significantly enhance the growth of your investments. By aiming for a more stable return profile, you can leverage the power of compounding and reduce the adverse effects of market fluctuations, leading to a higher overall dollar amount in your account.

Invest wisely, keep an eye on volatility, and remember that a smoother ride can often lead to a more prosperous destination.