Understand How Loss Aversion and the Sequence of Returns Impact Your Investments On February 9, 2024, the S&P 500 index marked a historic milestone by soaring past the 5,000 mark, …
Understand How Loss Aversion and the Sequence of Returns Impact Your Investments On February 9, 2024, the S&P 500 index marked a historic milestone by soaring past the 5,000 mark, …
Learn about the S&P 500 index's remarkable journey and its impressive growth amidst economic growth and rising interest rates.
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On October 7, Hamas launched a surprise terrorist attack on Israel, leading to the murder of hundreds and a declaration of war by Israel. The situation is volatile and has …
As the year ends, financial markets face turbulence due to rising interest rates and economic uncertainty.
Many investors are lured by the idea of taking “big bets” in a single stock to hit it big. However, this approach can be risky and often ignores potential losses. It is crucial to remain vigilant and know when to sell to avoid falling into drastic situations.
Discover the magic of investing in the stock market through compounding, patience, and persistence. Unlock your financial potential with our insightful guide to long-term wealth creation.
Volatility drag, often unnoticed by many investors, plays a significant role in the performance of investment portfolios, especially in markets characterized by high volatility. Understanding volatility drag is crucial for making informed investment decisions and managing long-term investment performance.
Volatility drag refers to the negative effect of investment volatility on compound returns over time. It occurs because losses have a more significant impact on portfolio value than gains of the same magnitude. For example, if an investment loses 10% one year and gains 10% the next, the investment will not return to its starting value due to the mathematical asymmetry between gains and losses. This phenomenon underscores the importance of minimizing large fluctuations in investment value to protect long-term returns.
The mathematical principle underlying volatility drag is relatively straightforward but profound in its implications for investors. The key concept is that percentage gains and losses are not symmetrical. A 50% loss requires a 100% gain to break even, not a 50% gain. This asymmetry means that volatility (up and down movements in price) can erode the compound growth rate of an investment, even if the arithmetic mean of the returns seems healthy.
Consider an investment with the following annual returns: +20%, -15%, +10%, and -5%. While the arithmetic mean of these returns might suggest a modest positive performance, the compound annual growth rate (CAGR) would tell a different story, factoring in the volatility drag and showing a lower effective return than the arithmetic mean would suggest.
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