Volatility’ is perhaps one of the more commonly used words in the investment dictionary. Put simply, volatility drag is a function of the cruel maths that govern the difference between average returns and compounded returns.
Volatility: The Maths
The idea is very simple, if a portfolio falls in value, it needs to work harder to go back to its initial value. Take for instance, a £100,000 portfolio. It falls 10% in Year 1 and recovers 10% in the following year. The portfolio should be back to the initial amount of £100K right?
After all, the arithmetic average annualised return is 0% isn’t it?
Well, wrong! The portfolio fell by 10% in Year 1, so your initial investment of £100,000 is down to £90,000. To get back to the initial value of £100,000, you need the portfolio to grow at around 11%, not 10%. So the portfolio needs to work harder to get back up. If the portfolio only grew by 10% in the second year, it will be back to £99,000, not £100,000. The £1,000 leakage from the portfolio is down to volatility drag.
Volatility looks like this:
Impact of volatility on investments and pension portfolios
Another good way to visualise volatility drag is to imagine riding a bike up and down a hill. Going down the hill is a whole lot easier than climbing up.
Of course, volatility drag is a familiar concept for investors, or it should be. It comes with the territory. However, the stakes are much higher for clients drawing down their pension funds or portfolios. Volatility drag is exacerbated by withdrawals from portfolios, making it even harder for a portfolio to recover after a fall.
When investing, advisers often ‘coach’ clients to ignore the yearly market movement and focus on the longer term average returns. In essence, the message is that the destination is more important than the journey. However, for clients in retirement, the journey is as important as the destination.
Because clients are making regular withdrawals from their portfolio, short term volatility is an ever present danger. High volatility increases the chances that you’ll be taking money out when the portfolio is suffering, thereby locking in losses. It reduces both the expected value of those funds and the chances that there will be enough money to meet future needs.
You don’t need to grab your calculator
That would be a real drag! At Swindells Financial Planning we are well aware of the effect of volatility and factor this in when we advise our clients.
If you would like to arrange a consultation please use the contact form or call us on 01825 76 33 66.