Yes, investing can definitely be a drag. How? In short, it’s volatility.
Anyone that has purchased a leveraged ETF can attest to the problem. Leveraged ETFs that seek 2x benchmark returns for a single day can’t deliver it for periods longer than a day (just read their disclaimers). The reason is volatility drag: the detrimental impact volatility has on an investment held over time.
This is a very important, often overlooked, pain point for most investors. Most investors do not invest for a single period; they are long-term investors that prefer to compound returns over time. Yet, most portfolios have some volatility, so this drag effect negatively impacts buy-and-hold investors.
What’s more, portfolios with higher volatility and/or held longer will be subject to more drag. Larger negative fluctuations below a stock’s average arithmetic return simply require higher positive fluctuations to break even. This effect increases dramatically with increasing volatility. A stock with a negative return of 5% requires a positive return of 5.3% to break even; a negative return of 50% requires a 100% positive return.
It is this mathematical reality that fuels defensive equity investing.
Most of the mystery surrounding the “anomaly” of the outperformance of low volatility stocks or defensive equity investing disappears when we relate this drag concept to both security- and portfolio level-returns. For any two return-series – stocks or portfolios – that have the same single-period (arithmetic) return, the one with lower variance provides a greater compound (geometric) return when held over multiple periods.
See How Drag Affects 7% Return Targets
Investing defensively is largely about recognizing and avoiding uncompensated risk. That’s consistent with the economic tenet that states higher return generally requires more risk. Unfortunately, this statement is often flipped to make the false claim that more risk will result in higher return.
The chart below illustrates the point. Pension plans or individual investors with 7% return targets can get there with low or high volatility investments. Portfolio 1 and 2 both have the same 7% buy-and-hold (geometric) return, but portfolio 1 does it with half the volatility – and less arithmetic return!
The math to create this illustration is straightforward: a portfolio’s geometric (compound) return is equal to its arithmetic return minus half its variance (standard deviation squared). In other words, volatility drags down a portfolio’s return by 50% of its variance. The bigger the portfolio variance, the lower the geometric, or compound, return.
Turn Drag Into Delight
What does this mean for investors? It means that portfolios with lower volatility and lower arithmetic returns can match the geometric return of portfolios with higher volatility and higher arithmetic returns. Over the long term, the more reliable way of preserving and growing capital is a steady compounding of returns: win more by losing less.
That’s the essence of defensive equity investing.
Learn More
The longest bull market in history, persistently low interest rates and increasing longevity are driving many to take a hard look at defensive equities investing. That’s why we’re offering a fresh look at defensive equity investing.
The information expressed herein is subject to change based on market and other conditions. The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. This information should not be used as the sole basis for investment decisions. All content is presented by the date(s) published or indicated only, and may be superseded by subsequent market events or other reasons. Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal and fluctuation of value. Hypothetical performance results presented are for illustrative purposes only. Hypothetical performance is not real and has many inherent limitations. It does not reflect the results or risks associated with actual trading or the actual performance of any portfolio and has been prepared with the benefit of hindsight. Therefore, there is no guarantee that an actual portfolio would have achieved the results shown. In fact, there will be differences between hypothetical and actual results. No investor should assume that future performance will be profitable, or equal to the results shown. Hypothetical results do not reflect the deduction of advisory fees and other expenses incurred in the management of a portfolio.
