Volatility is the least recognized destroyer of wealth. Most investors have no idea of its negative impact. If two portfolios average 10% per year, shouldn’t they be equivalent? Not exactly.
Consider the example above: Both portfolios have an average return of exactly 0%. Both portfolios begin year 1 with $100,000. Yet, Portfolio 1 ends year 2 $24,000 behind Portfolio 2. The strong gain during year 1 for Portfolio 1 is more than eliminated by the loss during the second year. Portfolio 2, while earning less spectacular gains in year 1, ends the entire period with more dollars.
Investors should design portfolios to experience less fluctuation in returns. Lower volatility can result in a higher compound return and greater terminal wealth. Managing volatility is particularly important during a downturn. After experiencing a loss, a portfolio must earn an even higher return during future years to fully recover to its previous level.
Managing volatility risk is a critical part of portfolio management. We ignore it at our own peril.