Why volatility isn’t just a mental drain, but a money drain

A year of tariff drama and currency concerns has led many investors to start to look outside the US to boost their market returns. And while some have steered towards calmer waters, with a boost in European investments, others have turned towards emerging markets.

While both can offer their own set of perks to a portfolio, those looking at rockier markets have an extra consideration to factor into returns: even when high highs and low lows seem to average out, what are these peaks and troughs actually doing to the value of the investment?

It seems intuitive enough to think that if an investment goes down by 8% one year, and then up by 16% the next, this is still a great gain, because it still ends up being a gain of 8%. Easy enough maths, but unfortunately, not representative for portfolios

How does volatility drag work?

Why? Because the percent change is not the value we are measuring. Instead, we want to know how they money will perform that is facing that change. So, if you have £100 in the stock market and it loses 5% in a year, at the end of that year you’d be left with £95. The next year, if your investment gains 10%, your money will not increase to £105. Instead, it will be a 10% gain on £95, which is 104.50.

In this example, there’s a very minimal difference between the amount that an annual average would assume your investment has grown to, and the amount it actually is. But this 50 pence difference can quickly become significant.

The case of the tortoise and the hare: UK versus Brazil

The effects of volatility drag become much more apparent when looking at the long-term outcome in different markets. Take two very different economies – the slow-but-steady UK and the volatile Brazil.

In the past 10 calendar years, the annual return from each year of the FTSE 100 averages out to 6.7%, while the MSCI Brazil averages to 8.8% in sterling. Based on these averages, £1,000 put into the FTSE 100 would increase to £1,950.6 while in MSCI Brazil, this would become £2,403*. That’s almost a £500 difference.

But how did money in these markets perform in reality, not when using averages? The £1,000 in the FTSE 100 turned into £1,825, still a drop from the averaged-out gains, but within the same range. However, the £1,000 in MSCI Brazil turned into £1,347*. Not only a £1,000 difference from the starting amount, but less of a gain than the FTSE 100, despite having a significantly higher annual average gain.

But when looking at the percentage changes year by year, the numbers begin to add up. While the FTSE 100 still had some volatility, losing 1.3% in the first year to a gain of 11.95% in the second year, it looked miniscule compared to the range of MSCI Brazil, which plummeted 38% in the first year, to increase by 98% in the second year. This 98% gain dragged the average annual return up significantly, but because it happened right after the investment had lost over a third of its value, the gains were on a much smaller pot of money than that initial £1,000.

Modelling returns

Fortunately, when many fund managers show annualised returns, they use a geometric mean, rather than a typical arithmetic mean, to reach the percentage. This allows for a much more representative value of what has happened to the investment. Instead of summing the values and dividing by the number of values, for a geometric mean the values are multiplied together, and then this figure is taken to the root of the amount of numbers in the set.

So, to take the geometric average of values A, B, and C, you would multiply A*B*C, and then take the cube root of that result, since there are three values in the set. Notably, you cannot use negative numbers when calculating a geometric mean. Instead, you must create a proportion.

In the case of the decrease of 38% for Brazil, instead of multiplying by negative 38, you would subtract 0.38 from 1, to reach a value of 0.62. Then, you would multiply by 0.62 in your calculation.

Factoring volatility drag into portfolios

When creating a portfolio, it’s a common practice to attempt to build a return that is relatively stable over time. This strategy is often chalked up to peace of mind: if the return on a portfolio is smooth, investors can remain calm and are less likely to pull money out of the market, which can lead to large losses. This is certainly an important factor, but it’s not the only benefit of steady returns.

The other advantage is the mathematical upside. If a portfolio has a large downside risk, the returns it will need to create to make up for those market falls are extreme. It’s impossible to find a market that will not have some negative periods, but minimising how extreme those troughs are can make creating strong returns significantly easier.

The other advantage is the mathematical upside. If a portfolio has a large downside risk, the returns it will need to create to make up for those market falls are extreme. It’s impossible to find a market that will not have some negative periods, but minimising how extreme those troughs are can make creating strong returns significantly easier.

Figures do not factor in investment or platform fees. Data from FE Analytics.

Past performance is not a guide to future performance and some investments need to be held for the long term.