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How To Pocket More Of The Stock Market’s Return: Low-Volatility Funds
I can't understand how the author gets to $3,245 in this example:
"Say you gain 30% a year in three years and lose 20% in the other two... your $10,000 would be worth only $3,245..." Multiplying the corresponding factors together, 1.3x1.3x1.3x.8x.8 = 1.4061, so your $10,000 would be worth $14,061, not $3,245.
Also, "... because losses after good years would be bigger dollar amounts than average, and gains after bad years would be smaller dollar amounts." is not an explanation. The order of the gains and losses in the example doesn't matter; for example, 2x4 is the same as 4x2.
The arithmetic, the reasoning, and the writing are all a bit off in this column.
The best I can do in guessing where that $3245 (-67.55% total return) came from is that the writer flipped four signs. Instead of +30%, +30%, +30%, -20%, -20%, he used -30%, -30%, -30%, + 20%, -20%. That comes out to $3293. Still not what he got, but maybe he can't multiply, either
The sentence that Tony quotes does explain things, but barely manages to convey the thoughts. Tony is right that order doesn't matter, and that's what the sentence is saying: whether you gain 20% and then lose 20%, or you lose 20% and then gain 20%, you wind up with less than what you started with. That's because in the first instance you're losing a bigger dollar amount than you made, and in the second instance because you make back less than you lost.
If you want an investment with a surefire minimum volatility, have I got the perfect investment for you. It's called cash. Won't return a dime, but will do that consistently, year in, year out.
Reducing volatility may also reduce average returns. Vanguard said as much when it introduced VMVFX - that this fund would reduce volatility, but not maximize returns.
The basic premise of the column, that all else being equal, lower volatility yields better returns does not lead to the conclusion that you can do better with lower volatility. That's because all else is not equal - lower volatility doesn't come for free.
IMHO it gets worse at the end of the column, where the suggestion is to invest in funds that in turn pick low volatility stocks. I generally expect stocks with similar attributes (here, low volatility) to have higher correlation than stocks that have nothing in common. Combining low volatility stocks does not strike me as a way to reduce the volatility of a fund or of a portfolio.
In another description of VMVFX, Vanguard states: "We look at the interaction between the individual stocks and their cross-correlation with one another ... [to] further lower the overall volatility."
If your idea of investing in low volatility is in line with this - that you want a fund with low volatility, as opposed to a fund holding lots of securities with low volatility - then you might prefer something like USMV rather than the ETFs and funds mentioned. But do it because you want to sleep better at night, not because you expect reduced volatility to lead to superior returns.
Comments
"Say you gain 30% a year in three years and lose 20% in the other two... your $10,000 would be worth only $3,245..." Multiplying the corresponding factors together, 1.3x1.3x1.3x.8x.8 = 1.4061, so your $10,000 would be worth $14,061, not $3,245.
Also, "... because losses after good years would be bigger dollar amounts than average, and gains after bad years would be smaller dollar amounts." is not an explanation. The order of the gains and losses in the example doesn't matter; for example, 2x4 is the same as 4x2.
The best I can do in guessing where that $3245 (-67.55% total return) came from is that the writer flipped four signs. Instead of +30%, +30%, +30%, -20%, -20%, he used -30%, -30%, -30%, + 20%, -20%. That comes out to $3293. Still not what he got, but maybe he can't multiply, either
The sentence that Tony quotes does explain things, but barely manages to convey the thoughts. Tony is right that order doesn't matter, and that's what the sentence is saying: whether you gain 20% and then lose 20%, or you lose 20% and then gain 20%, you wind up with less than what you started with. That's because in the first instance you're losing a bigger dollar amount than you made, and in the second instance because you make back less than you lost.
If you want an investment with a surefire minimum volatility, have I got the perfect investment for you. It's called cash. Won't return a dime, but will do that consistently, year in, year out.
Reducing volatility may also reduce average returns. Vanguard said as much when it introduced VMVFX - that this fund would reduce volatility, but not maximize returns.
The basic premise of the column, that all else being equal, lower volatility yields better returns does not lead to the conclusion that you can do better with lower volatility. That's because all else is not equal - lower volatility doesn't come for free.
IMHO it gets worse at the end of the column, where the suggestion is to invest in funds that in turn pick low volatility stocks. I generally expect stocks with similar attributes (here, low volatility) to have higher correlation than stocks that have nothing in common. Combining low volatility stocks does not strike me as a way to reduce the volatility of a fund or of a portfolio.
In another description of VMVFX, Vanguard states: "We look at the interaction between the individual stocks and their cross-correlation with one another ... [to] further lower the overall volatility."
If your idea of investing in low volatility is in line with this - that you want a fund with low volatility, as opposed to a fund holding lots of securities with low volatility - then you might prefer something like USMV rather than the ETFs and funds mentioned. But do it because you want to sleep better at night, not because you expect reduced volatility to lead to superior returns.