Avoid Price Volatility

Some people advise making use of market volatility. Market go up and they go down. So according to this view, one should profit from market volatility, i.e. buy when prices go down and sell when prices go up. Of course, this is the classic 'buy low sell high' approach. Nice in theory, but not so easy to practise. After all no one really knows how low is low and how high is high, and for how long the low and high states will remain.

Then there are others who suggest that since volatility is a part of the market, one should accept volatility and expect markets to give good returns over a longer run. This view suggests that one assumes market volatility as given and ignore the period to period fluctuations in prices with an eye on the longer term end result.

However, market volatilty is not good for your portfolio.

Take an example as follows. There are two portfolios. Portfolio A is quite volatile with returns swinging between positive and negative. Portfolio B is very stable, returning the same 14% return year after year.

Lets assume that portfolio A has the following returns over a 10 year period:
50%, -20%, 65%, -30%, 40%, -15%, 100%, -45%, 70%, -35%

The average of all the above 10 figures is 18% per annum. One could be tempted to think that over a 10 year period, one would get a 18% return on the initial capital. That is unfortunately not true. A rupee invested at the begining of year 1 would become 2.004 after 10 years. This implies a return of only 7.2% per annum compounded (You can do your own calculations).

Because the returns were volatile, the compounded returns were less than half of that of the arithmetic mean. Volatility causes returns to diminish!

Instead if you assume that portfolio B gives a steady return of 14% per annum, a rupee invested in portfolio B at the begining of year 1 becomes 3.70 after 10 years.

Even though portfolio B has a lower arithmetic mean (14% per annum) than portfolio A (18% per annum), it still gives a higher compounded return than portfolio A.

A quick look at the BSE sensex from 31 March 1979 to 31 March 2008 paints a similar picture. The arithmetic mean of yearly returns comes out to be 27.6% per annum. However, the compounded returns are 19% per annum.

The implications of this need to be noted.

First, we tend to dislike volatility on a psychological level. We generally dont like our portfolios to keep swinging wildly. We feel uncomfortable and anxious when volatility kicks in. But on a returns plane as well, volatility (or more correctly, downside volatility) tends to reduce returns regardless of the order in which the volatility occurs. (A positive 20% and a negative 20% leads to a negative 4% absolute regardless of the order in which returns come in). So when markets become volatile, we are well advised to trade less or not at all.
Secondly, if you are a long term investor, you will benefit even more by minimizing volatility in your portfolio. Considering the sensex example above, at 27.6% since 1979, the sensex would have been at 117400 and not 15644 as of March 31 2008! This is a multiple of close to 7.5. i.e. by avoiding volatility you could have been more than 7.5 times richer than by accepting volatility.

It is a common belief that if you know what to buy and buy it at the right time, the money taps would be opened for you. I have maintained my stance that what to buy and when to buy and not as important as it is made out to be. There are many other hidden factors (like avoiding volatility) that are quite neglected from our investing plans. It may not be a bad idea to consider means of avoiding portfolio volatility.