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Compounding and Volatility

OWNING A MIX of stocks, bonds, cash and alternative investments can reduce the chances of a huge short-term decline in your portfolio’s value. That’s crucially important, because the math of investment losses is brutal. If you lose 10%, you need to make 11% to get back to even. If you’re down 20%, you need a 25% gain to recover the money lost. What if you lose 50%? Now, it’ll take a 100% gain to make you whole.

Imagine two portfolios. Over the next five years, the first portfolio notches annual returns of 15%, -10%, 25%, -15% and 10%. The second portfolio has annual returns of 5%, 10%, 5%, -5% and 10%. If you add up the annual returns for each portfolio and divide by 5, you get a simple average of 5 for both portfolios. Yet the cumulative gain for the second portfolio was 27%, while the first portfolio earned just 21%. What explains the difference? The first portfolio had a couple of bad down years, which it struggled to recover from.

To reflect this, mutual funds report their performance using compound average annual returns. This annualized gain is the return the funds would need to earn each year to produce the cumulative amount made for shareholders over, say, the past five or 10 years. For instance, our first portfolio had a five-year compound annual return of 3.9%, while our second portfolio had an annualized gain of 4.9%. Want to learn more about compounding? Check out the chapter on investment math.

Clearly, avoiding big portfolio declines can help your portfolio’s performance. But to get the full benefit, you need to layer on an additional strategy: rebalancing.

Next: Rebalancing

Previous: Measuring Volatility

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