Beware the Volatility Tax

Have you ever heard of the volatility tax? In case you haven’t, it’s the drag exerted on investment returns from volatility.

In other words, even if two different investments provide the same average annual returns, the investment with more volatility will deliver lower total returns. Let me illustrate.

Investment #1
Assume you invested $1,000,000 in an asset that returned 7% each year for three years. The value of your investment at the end of the three years would be $1,225,043 for a 22.5% total return. See below:

 

Investment #2
Now assume you invest $1,000,000 in an asset that returned 10% in year one, lost 14% in year two, but then made 25% in year three. The average return was also 7% like in the first example above, but the value of the investment at the end of the three-year period would be just $1,182,500, or $42,543 less. See below:

 

Investment #2 provided a lower total return than investment #1 even with the same average annual return because of the volatility. Investment #1 had no volatility whereas investment #2 had a lot of volatility. To understand how this works remember that a 50% loss requires a 100% gain just to get back to even.

Hopefully this brief illustration highlights the importance of managing risk in a portfolio.

One way to reduce risk is to simply reduce your allocation to riskier assets (stocks) in favor of less-risky assets (high-quality bonds). That would reduce your volatility, but it also reduces your long-term return potential. As just one example, a 30% bond / 70% stock portfolio has greater return potential over 30 years than an 70% bond / 30% stock portfolio.

Another solution, which is rarely used by the vast majority of financial advisors, is to incorporate options into your portfolio. Options, if managed well, allow you to maintain greater exposure to stocks than you might otherwise while also protecting you against significant declines (i.e. reducing the volatility tax).

Therefore, incorporating options can potentially lead to greater long-term returns precisely because they are very effective at insulating against significant declines. Options may be a good solution for investors who tend to be very aggressive but are also worried about a significant market decline and don’t like bonds.

Let me know if you’d like me to take a look at your portfolio and offer some suggestions.

 

Past performance is no guarantee of future results. Not intended as individualized investment advice but as general education. Always consult your advisor, or me, before making any changes.

 

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