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This is not a new article. So apologies if this is a repost. In another thread there has been a spirited discussion on balanced funds starting off with WBALX. This is about lower volatility of returns compounding better than higher volatility of returns over time.
Thank you for the Moneyball reference. I really like investment analogies, but I especially love the baseball variety given my fondness for the game.
Analogies of all kinds teach practical lessons, enhance understanding, provide perspective, and hopefully supply some decision making guidance. The Moneyball article doesn’t fail on that scorecard.
I certainly agree with Ted’s comment that volatility and risk are not equivalents. Risk is a far more, multi-dimensional complex concept. But one partial measurement of risk is portfolio or investment volatility (as is the Sharpe ratio and others identified in Charles’ super MFO fund listings).
Portfolio volatility is a very useful measurement tool. By knowing a portfolio’s average return and its standard deviation (its volatility), using statistical tables for a Normal distribution, an estimate can be made for the likelihood that the portfolio will deliver a negative annual return.
More importantly, simply knowing average annual return and its standard deviation sidekick, an annual compound return can be precisely calculated. That’s of fundamental importance since end wealth estimates depend directly on annual compound (geometric) return and NOT solely on average annual return.
The author of the article did Monte Carlo simulations to demonstrate its significance to end wealth. That computer simulation was not necessary. A simple algebraic equation equates annual average return and its standard deviation to the much more meaningful compound return. Here is the relationship:
Annual Compound Return = Annual Average Return – 0.5 X Standard Deviation X Standard Deviation
Note that Compound return is always less than Average return because standard deviation always operates to degrade end wealth. It is a non-linear relationship so significant portfolio lowering of standard deviation is possible without seriously compromising expected portfolio returns. That’s one of the benefits accrued from portfolio diversification.
Another way to lower portfolio standard deviation is to choose individual holdings with low correlation coefficients to one another. The low correlation coefficients enter the analysis when calculating an overall portfolio standard deviation.
Comments
Regards,
Ted
http://money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/2013/06/07/investing-risk-and-volatility-arent-the-same_print.html
I told you so: Baseball is what makes America GREAT!
Thank you for the Moneyball reference. I really like investment analogies, but I especially love the baseball variety given my fondness for the game.
Analogies of all kinds teach practical lessons, enhance understanding, provide perspective, and hopefully supply some decision making guidance. The Moneyball article doesn’t fail on that scorecard.
I certainly agree with Ted’s comment that volatility and risk are not equivalents. Risk is a far more, multi-dimensional complex concept. But one partial measurement of risk is portfolio or investment volatility (as is the Sharpe ratio and others identified in Charles’ super MFO fund listings).
Portfolio volatility is a very useful measurement tool. By knowing a portfolio’s average return and its standard deviation (its volatility), using statistical tables for a Normal distribution, an estimate can be made for the likelihood that the portfolio will deliver a negative annual return.
More importantly, simply knowing average annual return and its standard deviation sidekick, an annual compound return can be precisely calculated. That’s of fundamental importance since end wealth estimates depend directly on annual compound (geometric) return and NOT solely on average annual return.
The author of the article did Monte Carlo simulations to demonstrate its significance to end wealth. That computer simulation was not necessary. A simple algebraic equation equates annual average return and its standard deviation to the much more meaningful compound return. Here is the relationship:
Annual Compound Return = Annual Average Return – 0.5 X Standard Deviation X Standard Deviation
Note that Compound return is always less than Average return because standard deviation always operates to degrade end wealth. It is a non-linear relationship so significant portfolio lowering of standard deviation is possible without seriously compromising expected portfolio returns. That’s one of the benefits accrued from portfolio diversification.
Another way to lower portfolio standard deviation is to choose individual holdings with low correlation coefficients to one another. The low correlation coefficients enter the analysis when calculating an overall portfolio standard deviation.
Great stuff; thanks again.
Best Wishes.