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.
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.
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