Why Volatility Also Matters

Diversification of assets is an prudent way to reduce risk in a portfolio. While the concept of diversification is important volatility is another factor that investors should focus on to generate higher returns.

Why does volatility matter?

The table shows the performance of two sample portfolios with both having an initial investment of $1.0 million:

  Start Value Year 1 Return Year 2 Return Average Return Compound Return Value at End of year 2
Poftfolio 1 $1,000,000 50% -50% 0% -13.40% $750,000
Poftfolio 2 $1,000,000 10% -10% 0% -0.50% $990,000

Both the portfolios have an average return of 0% in two years. However Portfolio 1’s value at the end of 2nd year is only $750,000 while Portfolio 2 lost only $10,000 and has a value of $990,000. The reason for the difference in performance is that Portfolio 1 is much more volatile. Portfolio 2’s lower volatility produces a higher compounded return.

So the key takeaway from this post is that if two portfolios have the same average return then the portfolio with the lower volatility will always have the higher end value.

Source: Why Volatility & Diversification Matters, Stewart Partners, Australia

Volatility in a portfolio can be minimized by avoiding highly volatile stocks such as IPOs, internet sector stocks, biotech stocks, penny stocks, etc.

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