Safety In Numbers
When investing, people too often try to seek out the highest number with very little though of the consequences. Whatever has the highest return must be the best investment. However, a crucial rule of investing is high returns always come with higher volatility. Large increases in value are often followed with large drops in value.
That is where diversification comes in. Through diversification, we know we will get some above average returns and we will get some below average, but it creates consistency. That stability in the portfolio will help you out in the long run and create a greater value at the end of the year.
As shown in the illustration above, lower volatility can result in a higher compound return and greater terminal wealth.
The concept of an average is easy to understand. 50 minus 50 equals zero just as 10 minus 10 equals zero, but compound return works differently. Let’s work through it. A 50% gain on $100,000 is $150,000. That is simple math. However, the 50% loss leaves us with $75,000. In contrast, the 10% gain gives us $110,000 and a subsequent $99,000 after the 10% loss.
Although Portfolio 1 experiences a strong gain in the first year, this gain is more than eliminated in year two. Portfolio 2 experiences a much smaller gain and loss during the two-year period, but the lower volatility of returns produces a higher compound return and preserves more portfolio value.
Managing volatility is particularly crucial during a market downturn. After experiencing a loss, a portfolio must earn an even higher return in future periods to fully recover to its previous level.
We’ve often discussed how difficult it is to pick the hot hand, showing that what was the best performer the previous year is often at the bottom of the list the following year. A proper portfolio doesn’t chase returns. It builds diversification, gathering returns from all the performers, and rewards you through the discipline of your investments