Also called: Variance drain, Geometric vs arithmetic return.
Gain 50% then lose 50% and the average return is zero, but you are down 25%. That is volatility drag in its simplest form: compounding cares about the product of returns, not their sum, and losses require larger gains to undo than the loss itself.
The consequence is that arithmetic averages systematically overstate what an investor experiences. A strategy quoting a 10% average annual return with wild swings may compound at 7%, while a steadier strategy averaging 9% compounds at 8.5% and ends up ahead.
This is one reason simple projections mislead. Multiplying a portfolio by an average return each year produces a path nobody could have achieved, because it silently assumes zero volatility.
It is also the argument for diversification stated precisely. Reducing volatility without reducing the average return raises the compound growth rate, which is why diversification is described as the only free lunch in investing.
Research on this
- Monte Carlo Simulation in Personal Finance: Why Projections Fall Short
- Timing the Market vs Staying Invested: 40 Years of S&P 500 Evidence
See also
- Monte Carlo simulation — Running a plan through thousands of randomly generated market sequences to report a distribution of outcomes, instead of one path from an average return.
- Real return — A return measured after inflation, showing the change in purchasing power. A 7% nominal return with 3% inflation is roughly a 4% real return.
- Asset allocation — The split of a portfolio across asset classes — equities, bonds, cash, and others — which is the primary determinant of both its expected return and its volatility.