Take the Smooth Road to Wealth Accumulation

I was cheered recently when a client referenced the deleterious effect negative returns have on wealth accumulation. He pointed out that a 25% loss requires a 33.3% gain to get back to flat. Steep losses are a killer when it comes to building wealth.

This reminded me of a related but less appreciated concept: large swings in short-term returns tend to reduce overall returns over  longer periods. To illustrate this effect, consider the two scenarios below for a $100 investment:

Which would you choose? Both scenarios have an ‘average’ return of 10% over the two years. However, Scenario 1 results in $121.00 after two years versus $120.36 for Scenario 2. Over a 20-year stretch, Scenario 1 grows to $673 while Scenario 2 (alternating 18% and 2% returns) grows to only $638—a difference of $35, which is 35% of the original $100 investment.

Bring in some negative numbers, and the wealth-degrading impact of volatility in returns is even more pronounced. That $100 invested with a return profile alternating between a 30% gain in one year and a 10% loss the next grows to just $481 over 20 years.

The drag of volatility is so significant that a higher ‘average’ return can actually result in lower long-term compounded returns. For example, alternate annual returns of +30% and -7% produce an ‘average’ return of 11.5%, but over 20-years, a $100 investment grows to only $667—less than the $673 from a stable 10% annual return.  

So, what to do with this? It is not possible to avoid volatility and periodic losses while invested in anything other than cash-like instruments. While we have not given up on our search for the Holy Grail (a checking account paying 10% interest, tax-free of course), we focus more on diversifying holdings among assets we expect to behave differently, helping smooth the return profile.

Diversification is a core tenet of our investment philosophy. One benefit of diversification is that it generally helps smooth returns—and smooth returns compound to greater wealth. This isn’t some math trick; we’re talking real dollars. We seek assets with return profiles that might offset each other’s volatility to a degree, dampening the ups and downs. But this only gets us so far. We also shy away from investments with wide ranges of unpredictable returns. While such investments may appeal to some as a form of ‘lottery ticket’ due to their potential high returns, we are naturally averse to such ‘swing for the fences’ thinking.

This isn’t to say we avoid taking risk. Rather, we carefully consider the way investments are expected to perform relative to others in our portfolios. We do this in part because we believe the best road to wealth accumulation is a smooth one.

Jeff Buck