Imagine that you are offered a choice between two different investment strategies. The first strategy has an average annual return of 1% with 5% volatility. The other has twice the average return (2%) but with four times the volatility (20%). If your time horizon is long — say 50 years — you may think that allocating to the strategy with the higher average return and not worrying about the ups and downs along the way is the better choice. You may take the view that because you are investing for the long term, you can afford to take more risk and over time you will be rewarded with higher returns. You sit back, ignore the noise, and reflect on how lucky your grandchildren are to have you managing their savings for them.
The chart below shows simulated track records for these two strategies over 50 years. Each track reflects a random series of returns that match the average return and volatility parameters of the strategy. The blue lines represent 10 simulated returns for the first, lower-return, lower-volatility strategy. The red lines represent 10 simulated returns for the second, higher-return, higher-volatility strategy.
Chart 1: Portfolio simulations over 50 years
1% average annual return with 5% volatility (blue) and 2% average return with 20% volatility (red)
The chart below shows simulated track records for these two strategies over 50 years. Each track reflects a random series of returns that match the average return and volatility parameters of the strategy. The blue lines represent 10 simulated returns for the first, lower-return, lower-volatility strategy. The red lines represent 10 simulated returns for the second, higher-return, higher-volatility strategy.
Chart 1: Portfolio simulations over 50 years
1% average annual return with 5% volatility (blue) and 2% average return with 20% volatility (red)
Source: Aberdeen Standard Investments, June 2020. Not representative of any ASI product or service – strictly for illustrative purposes only. Hypothetical positions are used here and actual markets conditions may have a different impact on the portfolio. No assumptions regarding future performance should be made.
The strategy with 20% volatility (red) has a much wider range of possible paths than the lower-volatility strategy. For most of the track record, it is very difficult to distinguish what is the sustainable, long-term expected return and what is just noise. More surprisingly, however, it becomes clear that despite having double the average annual return, the more volatile strategy generally underperforms over the long term. These simulations show the average total return at the end of the 50 year period for the lower volatility strategy to be 53%, compared to an average total return for the more volatile strategy of =-3% (oops!). Why is it that the strategy with double the expected annual return can not only underperform so much but also end up losing money over the long term?
The strategy with 20% volatility (red) has a much wider range of possible paths than the lower-volatility strategy. For most of the track record, it is very difficult to distinguish what is the sustainable, long-term expected return and what is just noise. More surprisingly, however, it becomes clear that despite having double the average annual return, the more volatile strategy generally underperforms over the long term. These simulations show the average total return at the end of the 50 year period for the lower volatility strategy to be 53%, compared to an average total return for the more volatile strategy of =-3% (oops!). Why is it that the strategy with double the expected annual return can not only underperform so much but also end up losing money over the long term?
Understanding the differences
The disconnect comes from looking at expected returns over discrete periods, such as a year, when instead of what investors really need to focus on — the realized compound rate of return. The compound (geometric) rate of return will only equal the arithmetic average rate of return if volatility is zero. As soon as you introduce volatility to the return series, the geometric IRR will start falling, relative to the average return.Table 1:
Source: Aberdeen Standard Investments, sample of 20 randomly generated track records with defined average return and volatility parameters, June 2020. Not representative of any ASI product or service – strictly for illustrative purposes only. Hypothetical positions are used here and actual markets conditions may have a different impact on the portfolio. No assumptions regarding future performance should be made.
The difference between compound returns and average returns is approximated over the long term by the relationship below:
Compound RoR = Average Return – (0.5 x Variance)
Using this formula, you can determine that for the higher-volatility strategy described earlier, half the variance (0.5x(0.20)^2) exactly matches the average return. As such, the expected long run IRR of the strategy would indeed be around zero. Furthermore, if you lose 50% one year, and make 50% the next, your average return may be zero but you’re still down 25%. This is commonly referred to as the “volatility drag.”
The difference between compound returns and average returns is approximated over the long term by the relationship below:
Compound RoR = Average Return – (0.5 x Variance)
Using this formula, you can determine that for the higher-volatility strategy described earlier, half the variance (0.5x(0.20)^2) exactly matches the average return. As such, the expected long run IRR of the strategy would indeed be around zero. Furthermore, if you lose 50% one year, and make 50% the next, your average return may be zero but you’re still down 25%. This is commonly referred to as the “volatility drag.”
… annual cost can be considered in the context of the potential benefits that come from lowering volatility and more effectively compounding returns.
This provides an initial framework for thinking about the costs and benefits of portfolio hedges. The annual cost can be considered in the context of the potential benefits that come from lowering volatility and more effectively compounding returns.
Until recently, the markets had experienced a multi-year period of unusually low volatility by historical standards. Now that volatility has returned, we expect the next few years to see, on average, significantly larger swings in asset prices, especially considering the current extreme settings for fiscal and monetary policy combined with rising geopolitical tensions.
Uncertainty and volatility aren’t signals for investors to exit the market, but while they persist, we expect investors will benefit over the medium term from having strategies available to them that can help manage downside volatility. Such strategies can reduce drawdowns, provide access to market liquidity during market dislocations, and improve overall compound rates of return. Furthermore, with a wider range of tools available today than ever before, it may be a good time for investors (even those who are bullish!) to look for hedges that have the right structure, available at the right price, to add value to their portfolios.
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Recognizing the importance of volatility
The key point here is that the volatility of your portfolio matters. Not just because it’s stressful to live through, but because reducing it can deliver significant benefits to your long-term, compounded returns. Putting on exposures with flat or even negative expected returns can still increase your total portfolio return over time if they lower your volatility profile sufficiently. It is meaningless, therefore, to look at the costs of hedges in isolation. Considering their overall portfolio effect and, more specifically, their effect on the downside volatility of a portfolio is critical. This said, investors need to be careful about strategies that reduce volatility by also sacrificing exposure to upside volatility. It may seem like a safe decision to sacrifice returns above a certain threshold, but missing out on extreme right tail events can also dramatically lower long-term returns.Until recently, the markets had experienced a multi-year period of unusually low volatility by historical standards. Now that volatility has returned, we expect the next few years to see, on average, significantly larger swings in asset prices, especially considering the current extreme settings for fiscal and monetary policy combined with rising geopolitical tensions.
Uncertainty and volatility aren’t signals for investors to exit the market, but while they persist, we expect investors will benefit over the medium term from having strategies available to them that can help manage downside volatility. Such strategies can reduce drawdowns, provide access to market liquidity during market dislocations, and improve overall compound rates of return. Furthermore, with a wider range of tools available today than ever before, it may be a good time for investors (even those who are bullish!) to look for hedges that have the right structure, available at the right price, to add value to their portfolios.
US-300620-120356-1